The impact of sovereign credit risk on bank funding conditions: new report from the Committee on the Global Financial System

Today the Committee on the Global Financial System (CGFS) released a report entitled The impact of sovereign credit risk on bank funding conditions. The report was prepared by a Study Group chaired by Fabio Panetta of the Bank of Italy.

This report examines the relationship between sovereign credit risk and bank funding conditions, how banks might respond to an environment of ongoing elevated sovereign risk and the implications for policymakers. This is an important topic, as sovereign credit risk is already a significant issue for European banks, and over coming years may have broader implications for global financial stability.

The report finds that increases in sovereign credit risk push up the cost and weaken the composition of banks' funding through several channels, reflecting the extensive role of government securities in the financial system.

Banks can mitigate the effects of increased sovereign risk by adjusting their operations, including by further diversifying the country composition of their sovereign portfolios and strengthening their funding mix. However, there are trade-offs for the banks in doing so, and they cannot fully insulate themselves. 

As a consequence, the official sector has a key role in minimising the impact of weaker public finance conditions on banks, though again, there are trade-offs. First and foremost, governments need to maintain sound public finances. Bank supervisors should also closely monitor the interaction of sovereign risk with regulatory policies that encourage banks to hold large quantities of public debt. Central banks might also consider having flexible collateral frameworks that, during severe crises, allow funding to be supplied against a broad range of collateral. However, this is not costless, and so should be used sparingly and with appropriate safeguards in place.

CGFS Chairman Mark Carney said that the report is a relevant and timely input to national and international discussions about managing the current circumstances of economic and financial strain.