Country Risk and Financial Stability

Version	Summary	Created by	Modification	Content Size	Created at	Operation
1		Paul-Francois Muzindutsi	--	2378	2023-11-23 08:49:46	\|
2	references update	Fanny Huang	Meta information modification	2378	2023-11-24 06:11:20	\|

This entry is adapted from the peer-reviewed paper 10.3390/risks11110198

An efficient legal and regulatory framework is essential to complement the capital buffer against country risk. Policies must be introduced to reduce country risk to enable African banks to adequately support the African economy in good and challenging times. Overall, country risk remains a threatening factor for bank stability, and consequently, banks need adequate capital to reduce the impact of country risk on bank stability in Africa.

country risk bank stability

1. Introduction

Banks play a major role in the economy as financial intermediaries for individuals, corporates, and governments, promoting economic growth and socio-economic development (Caselli et al. 2016). However, they are inherently prone to failures, which amplify the negative effect on a country’s economy (Montes et al. 2021). Banks are also major investors in government debt instruments (Fiordelisi et al. 2020). While banks have always contended with credit risk arising from lending to individuals and corporates, they are also faced with increased risk exposure from government borrowing (either local or foreign) that is deemed safe, as they are assigned zero-risk weights in the Basel Accord (BCBS 2009, 2017). This risk is evident from the 2023 bank collapse in the United States (three small- to mid-sized banks) and Switzerland because of excessive exposure to government debt. The incident arose from a government policy change to raise interest rates to slow down rising inflation in the country, which affected the carrying values of the government debt in the banks’ balance sheet before maturity, thus affecting short-term liquidity and resulting in bank panic (FDIC 2023; S & P Global 2023).

When a sovereign state cannot willingly honor its debt within the terms of its contractual agreement, it increases the country’s risk level (Brůha and Kočenda 2018). High country risk levels tend to influence bank failures because banking decisions are based on current economic conditions and future economic performance expectations (Montes et al. 2021). According to Maria et al. (2014), high country risk leads to losses of a bank’s holdings of sovereign debt and may impact it depending on its exposure to sovereign debts (Brůha and Kočenda 2018). Country risk can affect the entire total assets of a bank (Boumparis et al. 2019). Banks hold sovereign debts to diversify asset portfolios as collateral for interbank financing or to generate more liquidity (Buch et al. 2016).

There are credit-rating agencies that measure and rate the country risk levels of different countries. Then, the ratings are published. The top three global credit-rating agencies include Moody, Fitch, and Standard and Poor (S&P). They assess and rate the capability of a sovereign state to pay its debt without default in the present economic situation on the probability of a government default (Kara and Karabiyik 2015). The ratings reflect the macroeconomic conditions prevalent in a country. The changes in the ratings, either low (upgrades) or high (downgrades), may directly impact bank stability. South Africa, the most developed country in Africa, has been experiencing deteriorating economic growth for the past ten years with disappointing country risk ratings. Makrelov et al. (2023) found that the rising country risk increased the capital buffer of South African banks, leading to higher lending rates. In addition, a country with high exposure to country risk can lose foreign direct investment (FDI) to other countries with stable country risks. This may affect the banking sector’s stability.

Country risk differs from country to country and is likely higher in African countries than in developed countries (Muzindutsi et al. 2021). A downgrade of country risk ratings impacts poorer countries more than developed countries (Opoku et al. 2017; Fatnassi et al. 2014). The country’s risk downgrade may adversely affect the stability of African banks. For instance, developing countries compete for capital inflow from international investors. International investors rely on the country’s risk ratings to make investment decisions in countries deemed to be safe for investments and returns. The implications of downgrades for these developing countries competing for capital inflows is a loss of investor confidence, which may suddenly cease the capital inflow or instigate the panicked exit of investments in the country (Ahuja et al. 2017). For this reason, African banks may be vulnerable to higher country risks, which can affect bank stability.

Also, African countries are characterized by political instability, exchange rate volatility, high inflation, insecurities, lack of infrastructure, and slow economic growth (Triki et al. 2017). These unattractive conditions cause high country risk ratings. Other reasons African banks may be vulnerable to country risks; African banks are characterized by their fragility and vulnerability to failures due to capital inadequacies, non-performing loans, and weak banking regulations (Triki et al. 2017). In addition, many banks in African countries are not credit-rated due to lags in the compliance with Basel regulation changes. Thus, the access to wholesale funds in the international market is limited because African banks are assessed based on their country risk ratings (Opoku et al. 2017).

2. Conceptualization of Country Risk Ratings

Country risk is also referred to as sovereign risk. Country risk ratings reflect a country’s forward-looking perspective from the broad stance of its economic, financial, and political conditions (Hammoudeh et al. 2013; Muzindutsi et al. 2021). The ratings provide creditworthiness information about the government and its related sovereign bonds, which play an essential role in the international market (Montes et al. 2021).

More attention has been given to country risk following the 2008 global financial crisis (Brůha and Kočenda 2018). The crisis unveiled the macroeconomic imbalances in developed countries, leading to increased country risks (Brůha and Kočenda 2018). Empirical studies in the financial literature show that changes in country risk ratings, especially downgrades, affect banks in different ways: bank lending (Maria et al. 2014); non-performing loans (Boumparis et al. 2019); funding cost (Opoku et al. 2017); stock returns (Fatnassi et al. 2014); capital buffers (Makrelov et al. 2023); and bank stability (Davies and Ng 2011). The stock market reaction to a country risk downgrade is stronger than to an upgrade (Correa et al. 2014; Caselli et al. 2016; Fatnassi et al. 2014). Correa et al. (2014) found no statistically significant effect on stock returns following country risk rating upgrades but found a significant negative effect on stock returns following country risk rating downgrades on bank stocks in developed countries. The effect was stronger on banks in developed countries where governments were better positioned to provide support through government guarantees (Correa et al. 2014).

3. Country Risk and Bank Stability

Due to the nature of bank operations, banks are exposed to different potential risks for profits to maximize shareholders’ wealth. These risks may increase losses, which affect the stability of banks (Chiaramonte and Casu 2017). The effect of country risk on bank stability can be viewed from the financial fragility hypothesis (Al-Shboul et al. 2020). African banks are fragile and operate in a high country risk environment; changes in country risk levels can increase the probability of bank failure.

Several empirical studies have examined the impact of country risk on different aspects of banks. Country risk ratings represents the general risks present in the domestic markets of each country (Obalade et al. 2021). The rating level reflects the ability of a sovereign state to honor its obligations. From the macroeconomic perspective, country risk rating downgrades negatively impact economic activities and country returns (Lee and Lee 2019; Fatnassi et al. 2014). From the micro perspective, country risk rating downgrades can influence a bank’s reaction to reduce its loan supply and on-and-off balance sheet activities (Lee and Lee 2019).

Some studies (Lee and Lee 2019; Al-Gasaymeh and Samarah 2020; Junttila and Nguyen 2022) have examined the interaction between country risk ratings and bank performance. Junttila and Nguyen (2022) used a sovereign risk premium to examine the impact of country risk on the performance of banks in Europe. They found that country risk had a negative impact on the profitability of banks in Europe. The adverse effects suggest that the low-interest-rate environment in European countries causes the deterioration of bank profits. However, Al-Gasaymeh and Samarah (2020) assert that countries with low country risks command higher bank efficiency levels. But a very low country risk is not beneficial to banks.

For emerging countries, the country risk ratings were found to be important. According to Huang and Lin (2021), the impact of country risk ratings on bank stability was more pronounced in emerging countries than in developed countries. For instance, Lee and Lee (2019) examined the impact of country risk using changes in oil prices on the performance of Chinese banks between 2000 and 2014. Bank performance was measured using CAMEL (capital adequacy, asset quality, management efficiency, and liquidity) indicators. Using the GMM estimation technique, they found that a rise in oil prices triggered a negative effect on the performance of Chinese banks (Lee and Lee 2019). Additionally, Al-Shboul et al. (2020) examined the relationship between political risk and bank stability in the Middle East and North Africa (MENA). Their study found that political risk had a negative impact on bank stability.

A country banking sector development depends on an efficient institutional framework (Obalade et al. 2021). Therefore, the adverse effect of country risk has implications for banks and the economy at large. The persistence of country risk increases the fragility of banks in emerging economies.

Other studies reported that country risk affected banks because it increased funding costs (Lee and Lee 2019; Opoku et al. 2017). For countries with weak banking regulations, the increase in funding costs can be passed on to customers (Opoku et al. 2017), depending on the degree of loan elasticity and spread (Makrelov et al. 2023). This increases the interest rates on loans. As a result, lending costs become high, increasing loan losses (Triki et al. 2017) and negatively affecting the banks’ stability, especially African banks.

Some literature also considers the relationship between country risk and bank stability by focusing on bank asset quality; although, they tend to examine the link through banks’ holdings of sovereign debts. That banks tend to hold a high level of sovereign debt in their balance sheets (Correa et al. 2014). In this context, when changes in country risk ratings arise due to an increase in the probability of a government default, it directly impacts bank asset quality (Correa et al. 2014; Boumparis et al. 2019). The severity of the changes in country risk ratings erodes the quality of sovereign debts presented in bank balance sheets (Boumparis et al. 2019). Therefore, the impact on bank stability depends on the extent of the exposure to sovereign debts held in the bank’s books. Furthermore, Obalade et al. (2021) utilized fixed-effect models and generalized methods of moments (GMM) focusing on Nigerian banks. Their study showed that political risk reduced the asset quality of Nigerian banks, and the adverse effect can be linked to macroeconomic factors. Conversely, Ali et al. (2019) found that corruption positively influenced bank stability in Pakistan. For Islamic banks, they tended not to be influenced by political risk. This was supported by Al-Shboul et al. (2020), who found that political risk had no adverse effect on Islamic banks compared with conventional banks in MENA countries.

There is no consensus in the literature on the impact of country risk on bank stability. Some studies argue in favor of a low country risk. At the same time, a low country risk level negatively affects bank efficiency and profitability, especially in developed countries. Other studies showed that high country risk levels affected banks through funding costs and profitability. Studies on the impacts of country risk on bank stability, especially in the African context, are scarce despite the prevalent country risk in African countries.

4. Country Risk and Capital Adequacy

The empirical literature has been extended to consider broader factors that may affect bank stability (Klomp and Haan 2012; Huang and Lin 2021). These factors include bank regulations and supervision. Historically, some bank failures have been attributed to the incidence of high country risk levels (Fiordelisi et al. 2020). In Europe, the banking sectors in Greece, Spain, Italy, Portugal, and Ireland were affected in 2010 and 2012 by high levels of country risks (Williams et al. 2013). The effect caused large deposit withdrawals from the banking sector, totaling USD 425 billion within twelve months in 2012 (Grigorian and Manole 2017).

A distressed bank costs taxpayers money because of government bailouts (Correa et al. 2014; Boumparis et al. 2019). The 2008 financial crisis emphasized the importance of stronger bank regulations to enhance bank resilience against shocks when faced with extreme stress conditions (Vallascas and Keasey 2012).

Adequately capitalized banks signal stability and attract deposits, access to the wholesale market, and cheap sources of funds (Opoku et al. 2017). However, country risk downgrades can increase the capital buffers of banks. For instance, Makrelov et al. (2023) observe that country risk downgrades increase the capital buffers of South African banks that are Basel III compliant, which may increase the cost of lending that customers have to bear (Makrelov et al. 2023). Conversely, banks tend to reduce capital buffers when country risk ratings are favorable, making them vulnerable to sudden shocks and affecting their stability. For instance, Montes et al. (2021) showed that Brazilian banks used favorable country risk ratings to reduce their capital levels.

Many African banks are lagging in their compliance with higher Basel capital requirements. This is due to a lack of compliance with the changes in Basel capital requirements by African banks (Triki et al. 2017). Thus, many of these African banks may be more vulnerable to rising country risk levels, affecting their stability. Brůha and Kočenda (2018) found a negative relationship between banks’ capital and country risk levels. This implies that adequately capitalized banks are associated with low country risk levels. This is further supported by Adesina and Mwamba (2016), using the Generalized Method of Moment (GMM) estimation technique for South African banks, observed the positive impact of capital on the Zscore, a measure of bank stability. Their study implied that banks with lower equity had a higher probability of failure.

The compliance with higher Basel capital requirements creates a strong banking sector and improves bank risk profiles (Nkopane 2017; Soenen and Vander 2022). Soenen and Vander (2022) found that capital had a negative impact on country risk levels and that country risk levels are converted into bank risks, but a higher capital improved bank risk profiles. Anani and Owusu (2023) used the COVID-19 crisis as a measure of risk shocks to test the effectiveness of Basel capital adequacy. Using the event study methodology for US banks in the pandemic period and Zscore as a proxy for bank risk, their study found that capital adequacy effectively ensured bank stability. However, African banks are poorly regulated and the capital reserves to protect them are very low (Triki et al. 2017).

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