Sovereign risk and bank lending: evidence from 1999 Turkish earthquake

Summary

Focus

Banks are important providers of credit to both non-financial borrowers and governments. Lending to their own sovereigns increases their exposure to sovereign risk. An increase in sovereign risk directly affects bank balance sheets when they hold sovereign debt. The decline in asset value reduces bank net worth, which can then constrain bank borrowing and lending. The surge in government borrowing across both advanced and emerging markets, spurred by the Covid-19 crisis, has reignited these concerns. Recent turmoil in the banking sector further underscores the potential impact of valuation losses from sovereign securities.

Contribution

It is difficult to determine the impact of an increase in sovereign debt on bank lending because banking stress and sovereign crises tend to happen at the same time. Weak banks can lead to higher sovereign risk, and banks can adjust their holdings of sovereign debt ahead of a crisis. We use the 1999 Marmara Earthquake in Türkiye as an unexpected external fiscal shock in order to trace the impact of an increase in sovereign risk on the banks that hold the sovereign debt.

Findings

We find that an increase in sovereign risk reduces the net worth of banks holding sovereign bonds. During that period, this also worked through valuation effects on held-to-maturity securities recorded on the bank's balance sheet. This decline in net worth constrains the banks, leading them to reduce their lending to private non-financial borrowers. We find that about one half of the decline in lending following the earthquake is due to banks' exposure to sovereign debt. We rule out alternative explanations such as a decrease in loan demand or a decline in deposits.

Abstract

We use an exogenous fiscal shock to identify the transmission of government risk to bank lending due to banks holding government bonds. We illustrate with a theoretical model that for banks with higher exposure to government bonds, a higher sovereign default risk implies lower bank net worth and less lending. Our empirical estimates confirm the model's predictions. The exogenous change in sovereign default risk of Turkish government debt as a result of the 1999 Earthquake impacts banks whose balance sheets were exposed more to government bonds. The resulting lower bank net worth translates into lower credit supply. We rule out alternative explanations. Our estimates suggest this channel can explain half of the decline in bank lending following the earthquake. This underlines the importance of the bank balance-sheet channel in transmitting a higher sovereign default risk to reduced real economic activity.

JEL classification: E32, F15, F36, O16

Keywords: banking crisis, bank balance sheets, lending channel, public debt, credit supply, sovereign-bank nexus