Mr Gabi G. Afram
Practice Manager

Gabi G. Afram is the Practice Manager for the Finance Competitiveness and Investment (FCI) Global Practice of the World Bank in the South Asia Region based in Bangkok.

Before moving to Bangkok, Gabi was Lead Financial Economist based in Nairobi, and Program Leader for Equitable Finance and Institutions Program Leader (PL) based in Islamabad. Gabi has 30 years of experience in financial and private sector development. Gabi engages with policy markers and partners to help build stable, inclusive and efficient financial systems and a competitive and innovative private sector. Gabi has lived and worked in different parts of the world including Europe, the Middle East, Africa, Asia and North America, and has a wide experience in working for variety of institutions including the government, financial institutions, central banks, the private sector, the development community, and academia.

He holds two Masters’ degrees in finance and economics from the American University of Beirut, Lebanon, and the Kiel Institute of World Economics in Kiel, Germany.

Gabi is a native Arabic speaker, fluent in English, and has a good command of French.

Unwinding the Nexus

A much-needed Decoupling

In today’s world, we’ve never been more connected than before, and some connections are growing by the day – be it through social media, or modern communication tools or the like. Some of these connections connect people, others connect people and institutions, while others connect institutions. These connections are mostly for the good, but can also be bad, and they wax and wane over time. One of these connections that has waxed over the past few years, invariably for the worse between two important institutions, is the sovereign-banking nexus.

This nexus refers to the interdependent relationship between a country’s banking sector and its government. This relationship can create a loop where the financial health of banks and the fiscal health of the government are closely intertwined. While this nexus can provide stability and funding sources, it can also pose significant risks during periods of financial distress. Understanding the causes, risks, and potential solutions to unwind this nexus is crucial for maintaining financial stability and preventing systemic crises.

The nexus can be convenient for both parties. On the one hand, banks often hold substantial amounts of government debt as part of their asset portfolios. This is due to regulatory requirements, the perceived safety of government bonds (assigning it a zero-risk weight in capital adequacy calculations), and the need for collateral in financial transactions. On the other hand, governments prefer to borrow from local banks, especially in local currency, to reduce balance sheet risk and mitigate exposure to exchange rate fluctuations. This is especially so in Emerging Markets and Developing Economies (EMDEs), where capital markets are less developed and access to international capital markets requires credit-worthiness and comes with higher scrutiny.

But it comes at a cost. When banks hold large amounts of sovereign debt, their financial health becomes directly linked to the government’s fiscal position. The COVID-19 pandemic has brought the relationship between sovereigns and banks to the forefront, especially in emerging market economies. Bank holdings of domestic sovereign debt have surged, sovereign borrowing has increased many-fold, and sovereign credit risks have become more elevated. This can adversely affect banks’ balance sheets and credit supply, especially in countries with less-well-capitalized banking systems.

And the risks increase. One key risk is that this nexus can create a contagion effect, where financial distress in one part of the nexus quickly spreads to the other. For example, a sovereign debt crisis can lead to significant losses for banks holding government bonds, potentially triggering a banking crisis. Conversely, a banking crisis can lead to increased government spending on bailouts, worsening the fiscal position and potentially leading to a sovereign debt crisis. A second is procyclicality: The sovereign-banking nexus can exacerbate economic cycles. During periods of economic growth, banks may increase their holdings of government debt, while governments may increase spending. However, during downturns, the interdependence can lead to a vicious cycle of declining bank asset values, reduced lending, lower economic growth, and worsening fiscal positions.

A dire consequence of the waxing nexus is crowding out lending to the private sector and reducing investment. In a world of limited resources, increased government borrowing leads to a reduction in private sector lending and investment. This occurs because government borrowing can both divert lending from the private sector and drive-up interest rates, making it more expensive for private entities to borrow and invest. Banks tend to prefer to lend to the government rather than the private sector because government bonds are considered less risky – hurting small and medium-sized enterprises (SMEs) the most.

Everyone is affected. Banks, governments, as well as investors (in both government bonds and bank securities) are exposed to the risks posed by the sovereign-banking nexus. A deterioration in the fiscal position of a government or the financial health of banks can lead to significant losses for investors. And the public at large is affected, especially if the nexus results in a financial crisis, with the ensuing economic downturn, higher unemployment, and reduced access to financial services, as we have seen in several EMDEs since 2022!

The sovereign-banking nexus poses unique challenges for developing countries, which often have less diversified economies and weaker financial systems. In addition to limited access to credit for businesses and individuals, and higher borrowing costs due to perceived higher risks, developing countries are more vulnerable to external economic shocks, such as fluctuations in commodity prices or changes in global interest rates. The sovereign-banking nexus can amplify the impact of these shocks, leading to greater financial instability. High levels of government debt and the need to support the banking sector can constrain fiscal policy. This limits the government’s ability to invest in infrastructure, health, education, social protection and other critical areas for development and can exacerbate economic inequality in developing countries. Financial crises resulting from the nexus can lead to higher unemployment and reduced access to financial services, disproportionately affecting the poor and vulnerable populations.

So how to “unwind” the nexus? First and foremost, strengthening fiscal discipline and reducing government debt levels is essential. This can be achieved through prudent fiscal policies and improved domestic revenue mobilization. Additionally, encouraging banks to diversify their asset portfolios and reduce their reliance on government debt can help. This can be achieved through regulatory changes that assign higher risk weights to sovereign debt and promote the holding of a

broader range of assets; increasing capital requirements for banks to enhance their resilience to shocks; and better risk assessment, enhanced supervision, and the implementation of macroprudential policies. Third, establishing effective crisis management frameworks can help mitigate the impact of financial distress and support the implementation of coordinated crisis response strategies. Finally, developing local capital markets can facilitate better risk sharing and a more efficient allocation of capital, and improve the availability of long-term financing for households, firms, and governments.

Yes, the sovereign-banking nexus is a complex and multifaceted connection. It serves both parties well, but also poses significant risks to financial and economic stability, particularly in developing countries. Understanding causes and risks is crucial for policymakers, regulators, and financial institutions. More importantly, acting to prevent the nexus from waxing, and stepping up when needed to implement potential solutions could be critical in preventing a descent into crisis and mitigating unwanted economic pain and hardship. It is not easy, but that’s when leadership is needed! Like any relationship, maintaining a balanced and moderate sovereign-banking connection can lead to positive outcomes, while tipping too far in either direction may bring unintended consequences.