Home > Banks > Why Debt Crises Destroy Banks

Why Debt Crises Destroy Banks

August 17, 2011


After the U.S. downgrade by S&P, many pundits simply guffawed that the downgrade was a sideshow—a simple distraction from the true issues of debt and default. And that’s true to a certain extent—but if people actually think the downgrade is an issue—it may actually become one. A nation’s debt and the state of its banking system are intimately related. When there is a problem in one, you can be pretty sure there is a problem in the other. Any old notion of a “risk-free” government bond has quickly been laid to rest.

In the wake of Standard & Poor’s downgrade, the stability of other “AAA” sovereigns like the United Kingdom and France has been called into question. This, of course, has repercussions in the financial markets, where countries may suddenly find that their costs have gone skyward.

France, with the worst financial ratios amongst the Europe “AAA club” (France, Germany, Netherlands, Austria, Finland, and Luxembourg), has become the latest prime suspect. The French annual deficit is currently running at 7.1% of gross domestic product. While France has predictably fired back, saying its deficits and debts aren’t a problem, it is clear that their financial issues (and the Eurozone’s) aren’t going away any time soon. So how does this cause problems with their banks?

It’s all part of the fractional reserve banking and central bank linkages that force a country to backstop its banks whenever they become insolvent. But banks, under the fractional reserve system, are inherently insolvent, and as soon as people rush to pull out their currency, the problem can quickly spread. So how is that affecting the French banking system, and how will it plague the rest of the world? Last week, FT.com published this:

“French banks dropped sharply on Wednesday amid fears of a French downgrade, dragging down European shares.
“Société Générale plunged during the session, hitting a 2½-year low, and finishing on a drop of 14.7 per cent to €22.18. Other French banks also tumbled, with BNP Paribas falling 9.5 per cent to €35.61 and Crédit Agricole dropping 11.8 per cent to €6.07.”

Financial markets spotted France’s problems and quickly drove its bond yields and credit default swap spreads upwards—which in turn makes borrowing more expensive and weakened French banks. But there’s more to it than that.

A recent paper from the Bank for International Settlements, geekily called The impact of sovereign credit risk on bank funding conditions (PDF), highlights the vicious circle of sovereign debt and bank failures.

“First, losses on banks’ sovereign portfolios weaken their balance sheets, making funding more costly and difficult to obtain. Bank exposures to the domestic sovereign are typically quite large. For some banking systems, exposures to foreign sovereigns are non-negligible.
“Second, a deterioration in a sovereign’s creditworthiness reduces the value of the collateral that banks can use for wholesale funding and to obtain liquidity from the central bank. In the current period, the direct impact of this channel has been contained, owing to the small size of countries hit by sovereign tensions and the stabilising effect of central bank funding, which has allowed banks to obtain funds using illiquid collateral.
“Third, sovereign rating downgrades almost always flow through to lower ratings for domestic banks, as banks are more likely than other sectors to be affected by sovereign distress. As banks’ credit ratings decline, their wholesale funding costs rise, and their market access may diminish.
“Lastly, a deterioration in the creditworthiness of the sovereign reduces the funding benefits that banks derive from implicit and explicit government guarantees.”

You may be wondering why sovereign debt is such a big part of a bank’s balance sheet, and the reason is that sovereign debt historically has a higher capital rating than other assets—in other words, it’s supposed to be safer. Banks, in order to comply with regulations and internal policy, are required to hold a certain level of low-risk assets; thus they are basically forced to hold piles of sovereign debt as capital.

What all this banker’s mumbo jumbo means, in a nutshell, is that a sovereign debt crisis spells certain doom for that country’s banks.

Categories: Banks Tags: , , ,
%d bloggers like this: