Are banks in the hot seat?

In depth
This article is part of the dossier: Africa’s new debt deals

By Yara Rizk
Posted on Thursday, 16 June 2022 12:03

In a recent note, the IMF warns against the growing interdependence between banks and governments. According to the institution, this is a relationship that could sustain “a vicious circle” in these times of crisis.

This is part 5 of a 5-part series

To cope with the economic and social consequences of the pandemic, sub-Saharan states have become increasingly indebted to private creditors. These include private banks, such as Barclays in Mauritius and Botswana, Bank of Africa in Burkina Faso, BGFI Holding Corporation in Gabon, investment funds, and even commodity traders (Glencore in Chad).

‘Sovereign-bank link’

The current situation has increased private banks’ holdings of sovereign debt to a record 17% of their assets, according to IMF and World Bank figures. Economists point to a growing interdependence between banks and governments: the “sovereign-bank link”.

In emerging countries, more generally, sovereign debt represents a quarter of bank assets. Some governments are therefore heavily dependent on credit from their banks, which in turn depend on government bonds.

According to a recent IMF publication, “this linkage raises valid concerns”, as a large stock of sovereign debt “exposes banks to losses if public finances come under stress and the market value of government debt declines”.

As economic activity slows and tax revenues dry up, the public finance situation may deteriorate further, putting banks in a difficult position.

This risk is likely to force some banking institutions to reduce credit to individuals (businesses and households), which may harm the economic recovery. “As economic activity slows and tax revenues dry up, the public finance situation may deteriorate further, putting banks in a difficult position,” the report says. This link with banks could fuel a self-perpetuating vicious circle that could lead to government default, similar to what happened in Russia (in 1998), Argentina (from 2001 to 2002) and the current situation in Lebanon.

The need for government intervention

The deterioration of public finances could undermine investor confidence and jeopardise the profitability of these banks. Lenders would then be forced to seek government assistance, thereby worsening the state’s financial situation.

To avoid this type of scenario and to curb the interdependence between banks and states, IMF experts are calling for “prudence” and encouraging public authorities to programme “credible measures to reduce deficits in the medium term and to restore investors’ confidence in the sustainability of their public finances”.

As Timothy Adams, president of the Institute of International Finance (IFF) – which brings together the world’s private lenders – pointed out in a letter to the IMF, “rating agencies use economic loss for private creditors as a key measure for downgrades and/or selective default ratings”. This could penalise governments’ future access to financial markets.

In concrete terms, the IMF is advising banks to strengthen their “resilience” by maintaining a certain level of capital to absorb losses. To this end, the IMF believes it necessary to limit the amounts distributed to shareholders in the form of dividends and share buybacks, and suggests carrying out asset quality assessments “for capital adequacy purposes, in order to quantify hidden losses and identify weak banks […]”.

Other appropriate measures are also cited in the IMF note. These include: developing resolution frameworks for domestic sovereign debt to facilitate orderly restructuring and deleveraging where necessary; improving transparency on banks’ exposure to sovereign risk to assess the risks of over-leveraging; strengthening procedures for orderly bank liquidation where necessary; or building a broad and diverse investor base to strengthen market resilience.

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