BWBB3033

INTERNATIONAL BANKING

TOPIC 7
SOVEREIGN LENDING,
COUNTRY RISKS, AND
GLOBAL DEBT CRISES

1
 TOPIC OUTLINE

1. Definition of Risks
2. Global Debt Crises
3. International Banking Crises
4. Bank Crashes

2
 Introduction
The shift from domestic to cross‑border lending
adds a new layer of risk, and therefore risk
management, to the banker's portfolio.
In addition to the everyday issues of credit
analysis that shadow every financial transaction,
new and more challenging concerns arise with
regard to the provision of overseas finance,
such as foreign exchange risks, legal risks, and
country risk.

3
The additional risks involved in international
lending are as follows:
Quality of management
Quality of information, relating to worries about
different accounting system ­"fudging" of data,
and timeliness of data
Liquidity / refinancing risks (there are very few
lenders in some markets, and global capital
flows can be erratic and unpredictable)
Foreign exchange risk
Legal risks relating to the enforceability of
contracts
Corruption
Personal safety
4
 The bottom line: All cross‑border loans by
international commercial or investment banks
involve country risk – the possibility that these
loans will be impaired by economic or political
events in the foreign country.
Bankers involved in cross‑border lending are
exposed to a variety of factors that could make
the borrower unable (or unwilling) to service its
loan.
Most important, the individual borrower's ability
to meet its external debt obligations is influenced
not only by its own circumstances, but also ­by the
ability of the country as a whole to meet external
obligations.

5
 Thus, when a bank participates in international
lending or securities underwriting, it must assess
country risk as well as the creditworthiness of the
individual borrower.
The bank needs to set limits on its exposure to
each country, usually in the form of overall
country limits as well as sub-limits for different
maturities, individual borrowers, industries ­and
regions. This is the process that we call country
risk analysis.

6
 Special issues in Cross‑Border Lending

In assessing cross‑border risk and setting

limits on exposure, the banker is also aware
of the special issues that affect cross‑border
lending.
One enduring question revolves around how
to assess different classes of borrowers in
international markets.
Walter Wriston, the former chairman of
Citibank, is known for (among other things)
his famous pronouncement that countries do
not go bankrupt.

7
The idea is that countries have control over their
own supply of money (they can always print
more), and so they cannot go bust.
While theoretically true, this sentiment can lead
us into dangerous territory when it underpins
the standard assumption that governments are
better credit risks than private sector
companies.
One way of examining this is to realize that the
present value of a country's future national
income‑the best definition of its wealth‑must be
greater than its external liabilities.'

8
 Hence countries do not go bust, Governments
do!
Moreover, countries may reinvent
themselves‑witness the disappearing nations of
Central & Eastern Europe such as
Czechoslovakia & the Soviet Union (in 1990s)
Thus it appears that in some cases private
sector companies may be longer‑lived and
credit-worthier than sovereign borrowers.
(Would the rational banker prefer lending to
the government of Albania or to Microsoft?) –
Think!
Dealing with any political entity is fraught with
risk.  
9
 The issue of legal recourse and discipline
further complicates lending overseas, whether
to private or sovereign borrowers.
Among the unusual legal characteristics of
international lending is the sad reality that
legal recourse against a defaulting
government offers little protection to the
lender. For obvious reasons, creditors are
reluctant, and often unable, to seize the
assets of deadbeat governments.

10
 Definition of Risks
What is country risk?
Conceptually, this refers to the possibility that a
borrower will be unwilling or unable to service
its debt in a timely fashion - the risk from
cross‑border lending that arises from events to
some degree under the control of the
government of the borrowing country.
More precisely, a definition of country risk
should encompass the following factors:

11
 Political Risk
The risk that political factors might impair a
borrower's ability to repay and it encompasses a
vast array of possible events, ranging from
nationalization or expropriation to damage from
civil strife, political turmoil, and corruption.
Refers to the possibility that political decisions
or events in a country will affect the business
climate in such a way that investors will lose
money, or not make as much money as they
originally expected.

12
 Political Risk
Political risk forecasting involves an attempt to
project "harm" to the investor resulting from
political decisions.
For example:
The departure of a (relatively) reformist president in
Venezuela in 1993 was followed by the accession of
the elderly populist Rafael Caldera, who immediately
imposed a punishing regime of price and foreign
exchange controls.
The fall of Suharto in Indonesia in 1998, which led to
a major debt rescheduling, is another potent example.
Compared with most types of economic business
forecasting, political risk forecasting remains a very
underdeveloped art.

13
 Transfer Risk
The risk that a commercial borrower might
be unable to service its debt because the
government restricts access to foreign
exchange.
In other words, the commercial borrower
has earned sufficient revenue to service the
debt, but is not permitted to convert local
currency into foreign currency for the
purposes of debt service.

14
 Sovereign Risk
The risk that the government as a borrower
may prove to be un-creditworthy.
Refers to the risk that the sovereign borrower
(or a private borrower with a public
guarantee) will be unwilling or unable to make
payments on its foreign obligations.
One of the most recent of sovereign defaults,
of course, was the case of Russia in 1998,
followed in 1999 by Ecuador.

15
 From the banker's point of view, country risk
refers to the potential for loss of assets that the
bank has loaned across borders in a foreign
currency.
Thus, where sovereign risk relates to the credit
risk of the government as borrower, country risk
involves the credit risk of all borrowers in the
country taken as a whole.

16
Methodology of Country Risk Analysis
The assessment of country risk, then, involves
both qualitative and quantitative analysis of
political, social, economic, and natural conditions
in the country in which the borrower operates;
additionally, it requires a judgment of the
degree to which these factors will affect the
borrower's ability to service its loans.
In practice, country risk assessment is
dauntingly complex, incorporating a vast array
of social, political, psychological, historical,
political, and social factors.

17
 1) Political Analysis

An important facet to the political country risk

analysis challenge is an attempt to predict the
willingness of sovereign governments to
continue servicing foreign debt.

Variables used to assess this may include any or

all of the following:
Depth and experience of government
bureaucrats
Political intrusiveness on economic
management
18
 Political links with foreign partners
Past behavior under stress
Regime legitimacy and stability
Ethnic tensions
Corruption
Political turmoil

19
 2) Economic Analysis
Assesses the probable future economic
performance of the country, as an essential step
to determine the country’s likely future ability to
service its foreign debt.
This analysis should include at a bare minimum:
Monetary and fiscal policy
Global economic environment
Natural resources
Export diversification
Stability of the banking industry
GDP growth and inflation rates

            
20
 3) Financial Analysis

Finally, analysts examine various indicators of

a country’s international liquidity position, to
provide further clues as to its future capacity
to service foreign debt.
The indicators include:
Foreign indebtedness, both in absolute terms and
relative to GDP
Debt service payments relative to exports
Current account
Capital inflows/outflows
Exchange rate stability

21
 Debt Crises
Debt crisis is defined as -- When a country
cannot or will not pay the interest repayments
on a debt. In the case of a country these are
its external debt commitments.
In the 1980s there was a major international
debt crisis because several less developing
countries in Latin America and Africa
defaulted on their debt repayments.

22
 Latin America Debt Crisis 1980s
The crisis began on August 12, 1982, when Mexico
unable to meet its obligation to service an $80
billion debt (mainly dollar denominated).
The situation continued to worsen, and by October
1983, 27 countries owing $239 billion had
rescheduled their debts to banks or were in the
process of doing so.
16 of the nations were from Latin America, and the
4 largest— -- Mexico, Brazil, Venezuela, and
Argentina— owed various commercial banks $176
billion, or approximately 74 percent of the total LDC
(less-developed-country) debt outstanding.
23
 Latin America Debt Crisis 1980s
Of that amount, roughly $37 billion was owed to
the eight largest U.S. banks and constituted
approximately 147 percent of their capital and
reserves at the time.
As a consequence, several of the world's largest
banks faced the prospect of major loan defaults and
failure.

24
 List of global debt crises

1. 1982 – Latin American debt crisis

2. 1997 – Asian financial crisis
3. 1998 – Russian financial crisis
4. 2001 – Argentine economic crisis
5. 2015 – Greek government-debt crisis (failed to
make €1.6 billion payment to the IMF)

25
 Financial Crisis
 A financial crisis occurs when an increase in
asymmetric information from a disruption in the
financial system prevents the financial system
from channeling funds efficiently from savers to
households and firms with productive investment
opportunities.
 Financial crises can begin in several ways:
 Mismanagement of financial liberalization
 Asset price booms and busts
 Failures of major financial institutions

26
 Deterioration in Financial
Institutions’ Balance
sheet

Asset Adverse selection and Increase in

price Moral hazard interest
decline problems worsen rates

Increase in
uncertainty

27
 Bank Crisis
Banking problem can often be traced to a
decrease the value of banks’ assets.
When asset values decrease substantially, a
bank can end up with liabilities that are bigger
than its assets (meaning that the bank has
negative capital, or is “insolvent”).
Or, the bank can still have some capital, but
less than a minimum required by regulations
(this is sometimes called “technical
insolvency”)
28
 Bank Crisis
Bank problems can also be triggered or deepened
if a bank faces too many liabilities coming due
and does not have enough cash (or other assets
that can be easily turned into cash) to satisfy
those liabilities.
A (systemic) banking crisis occurs when many
banks in a country are in serious solvency or
liquidity problems at the same time—either
because there are all hit by the same outside
shock or because failure in one bank or a group
of banks spreads to other banks in the system.

29
 Bank Crisis
In some cases, the crisis is triggered by depositor
runs on banks.
The banking crisis can start with:
 Financial liberalization or innovation
 Weak bank regulatory systems
 Government safety net
Financial liberalization can promote competition
but also can lead to an increase in moral hazard:
-- excessive risk taking on the part of banks
particularly if there is lax regulation and
supervision.

30
 What Causes Crises?
Banks are regarded as being more vulnerable to
failures than other companies - they are often
perceived as being more fragile than many other
firms and more open to contagion.
Three reasons support this view:
Low capital‑to‑assets ratios (high leverage),
which provides little room for losses
Low cash‑to‑assets ratios, which may require
the sale of earning assets to meet deposit
obligations

31
 What Causes Banking Crises?

High demand debt and short‑term debt to

total debt (deposits) ratios (high potential for
a run), which may require hurried asset sales
of opaque and non-liquid earnings assets with
potentially large fire‑sale losses to pay off
running depositors.

32
 What Causes Banking Crises?
Fierce competition between financial institutions
Long credit cycles in which banks have been
able to continue lending for a long period to
increasingly more indebted borrowers
Bank failures can also be caused by financial
fraud.
Bank run - which occur when individual
depositors suddenly demand money because of
concern about the safety of their deposit. The
most vivid impression of a run on a bank is that
of crowds of people rushing to the bank and
demanding back their money.
33
 What Causes Banking Crises?

Macroeconomic volatility, both external and

domestic
Lending booms, asset price collapses, and
surges in capital inflows (as in Chile in the early
1980s)
Increasing bank liabilities with large maturity or
currency mismatches
Inadequate preparation for financial
liberalization, which allows banks to the
excessive risks in areas where they have little or
no experience (as in Nordic countries in the late
1980s and early 1990s)
34
 What Causes Banking Crises?

Heavy government involvement and weak

controls on connected lending (Indonesia and
Korea in the late 1990s)
Weakness in accounting, disclosure, and legal
framework (as in Asia in 1997‑98)
Exchange rate regimes that are open to
considerable volatility

35
 Example of Banking Crises
Iceland, Ireland, Luxembourg, Netherlands,
Belgium, United Kingdom, United States, and
Germany banking crises 2007-2009.
Mexico banking crisis 1994-1996
Malaysia banking crisis 1997-1999.
Thailand banking crisis 1997-2000.

36