The Dilemma of International Diversification: Evidence from the European Sovereign Debt Crisis

• DOI: http://doi.org/10.1111/ajfs.12293
• Published date: 01 April 2020
• Date: 01 April 2020

The Dilemma of International

Diversification: Evidence from the European

Sovereign Debt Crisis*

Bill B. Francis**

Lally School of Management, Rensselaer Polytechnic Institute, United States

Iftekhar Hasan

Fordham University, United States

Bank of Finland, Finland and University of Sydney, Australia

Gergana L. Kostova

AIG Group, United States

Sami Ben Naceur

International Monetary Fund, United States

Received 31 July 2019; Received in current form (1

st

revision) 27 January 2020; Accepted 1 February 2020

Abstract

This paper tests how capital markets value the international diversification of banks in good

and in bad economic times by investigating changes in domestic and foreign sovereign debt

ratings before and during the European sovereign debt crisis. Tracing 320 European banks in

29 countries and 226 credit rating announcements for European sovereigns between 1 Jan-

uary 2001 and 15 August 2012, we show that the market values banks with access to foreign

funds. Despite occasional adverse effects immediately following negative news regarding

sovereign credit rating changes, international diversification was found to be beneficial to

European banks, especially during periods of distress.

Keywords International diversification; Banks; Sovereign debt crisis; Europe

JEL Classification: F23, F61, G01, G14, G15, G21

1. Introduction

Crises can be difficult or even impossible to predict, especially when they concern

developed, economically stable countries. Therefore, banks can benefit significantly

*The authors are thankful to an anonymous reviewer, the editors (L. K. Ng and K. Park), R.

Alsakka, and O. A. Gwilym for helpful comments and guidance. The usual caveats apply.

**Corresponding author: Lally School of Management, Rensselaer Polytechnic Institute, Troy,

NY 12180, United States. Tel: +1-518-276-3908, email: francb@rpi.edu.

Asia-Pacific Journal of Financial Studies (2020) 49, 299–346 doi:10.1111/ajfs.12293

©2020 Korean Securities Association 299

from pursuing strategies that can help keep them afloat in critical situations such as

the recent European sovereign debt crisis. In this paper, we find that the market

valued the international diversification of banks positively during the most critical

periods of the crisis. More specifically, geographic diversification, income diversifi-

cation, and maintaining a United States cross-listing were all shown to be beneficial

to banks when their home sovereigns as well as foreign sovereigns in which they

maintained subsidiaries failed to sustain their financial and economic stability.

Backed by these findings, we discuss some strategies to alleviate banks’ losses in

times of great distress.

In late 2008, it became apparent that several major European Union (EU) and

EU Community countries —including Greece, Ireland, Italy, Portugal, and Spain

(often referred to as GIIPS or PIIGS, henceforth GIIPS), among others —would be

unable to repay or refinance their sovereign debts. Anticipating the outcom e of this

crisis, the EU took various measures to prevent a potential sovereign debt default.

1

Despite all efforts, however, many euro area countries’ sovereign debt ratings were

downgraded, indicating an increased likelihood of default.

The literature shows that a potential sovereign debt default can result in numer-

ous costs for that country, including reputational costs, international trade exclu-

sion costs, political costs to the country’s authorities (Borensztein and Panizza

2009), and so on. Most importantly, the banking system suffers significantly

2

due to

increased cost and reduced availability of funding. This results in banks choosing or

being forced to lend less money (de Haas and van Lelyveld 2006; Popov and Van

Horen 2015; Deli and Hasan 2017),

3

and thus, the country’s economy shrinks

(Ongena et al. 2015; Abbassi et al. 2016; Behn et al. 2016; Bremus and Neugebauer

2018). It becomes more difficult for governments to service their debt through tax

revenues, consequently increasing the risk of a sovereign debt default and bringi ng

the country back to the beginning of this vicious cycle (Acharya et al. 2014). Fur-

thermore, the banking sector’s requirement for interconnectedness within and

1

For instance, in May 2010, the European Financial Stability Facility (EFSF) and the European

Financial Stability Mechanism (EFSM) were created in order to safeguard financial stability in

the EU by providing temporary financial assistance to EU member states in need, issuing several

stimulus packages in order to avoid potential sovereign debt defaults. In addition to the EFSF

and EFSM, the International Monetary Fund (IMF) has also provided financial help to EU

Member States. Table A1 in Appendix A summarizes rescue package details and their announce-

ment dates, as well as the dates when the decisions to create the EFSF and the EFSM were taken.

2

See Committee on the Global Financial System (2011) for a detailed discussion of the effects

of the sovereign debt crisis on banks.

3

Popov and Van Horen (2015) show that during the financial crisis, European banks exposed

to GIIPS sovereign debt significantly reduced syndicated lending especially to foreign borrow-

ers other than the US, increasing their home bias.

B. B. Francis et al.

300 ©2020 Korean Securities Association

between countries can facilitate spillovers, especially if the affected country is part

of an economic or monetary union (like the EU or the euro area).

There are four main transmission channels through which sovereign risk affects

bank funding (Committee on the Global Financial System, henceforth CGFS 2011).

The most obvious is through a bank’s holding of government debt, which is directly

reflected on the bank’s balance sheet. The European Banking Authority’s 2010 bank

stress test

4

shows that while banks domiciled within the euro area are mostly

exposed to their home sovereigns’ debts (Acharya and Steffen 2015; Bremus and

Fratzscher 2015; Cassol and Koulischer 2019), they are also exposed to foreign

sovereigns’ debt (Blundell-Wignall and Slovik 2010; Bolton and Jeanne 2011). Sec-

ond, as sovereign risk increases, the value of a bank’s collateral decreases, likewise

decreasing the bank’s access to wholesale funding.

5

Third, sovereign ratings often

act as ceilings for all domestic issuers of debt (including banks),

6

which further lim-

its the home banks’ funding choices. In addition to this, institutional investors,

who are only allowed to hold investment-grade bonds, may be forced to liquidate

their bank bond holdings if their ratings fall below the investment level.

7

Lastly,

increased sovereign risk reduces the benefits that banks can receive from implicit

and explicit government guarantees.

8

4

See http://www.eba.europa.eu/EU-wide-stress-testing/2011/2011-EU-wide-stress-test-results.a

spx for further details.

5

See Bolton and Jeanne (2011) for a more detailed discussion of the spillover effect from

sovereign debt crises to banks through the collateral transmission channel under financial

and fiscal integration.

6

This means that the credit ratings of all issuers within a country may not exceed the sover-

eign one. This rule is particularly problematic in times of distress, as it may further exacer-

bate the economic situation in the country. Williams et al. (2013) show that sovereign rating

changes in emerging markets are often followed by bank rating changes in the same direc-

tion, although the strength of this relationship is dependent on certain characteristics of the

country and bank in question.

7

Bonds with ratings lower than BBB-/Baa are considered speculative-grade.

8

Explicit and implicit government bank funding guarantees aim to reduce the costs of and

improve access to funding for banks. Explicit guarantees are formal agreements that a govern-

ment will prevent the potential default of a bank on its bonds, while implicit guarantees refer

to the market’s expectations that a government will prevent a bank from defaulting on its

bonds. It is most relevant for banks that are essential for the economy, following the “too big

to fail” logic. The value of explicit guarantees is measured as the difference in the yields of a

bank’s government-guaranteed and non-government-guaranteed senior bond. The value of

an implicit guarantee is measured as the difference between a bank’s “issuer rating” (which

takes into account the likelihood of government or other support in case of a bank’s poten-

tial default) and its “standalone rating” (which only takes into account the bank’s own cred-

itworthiness, disregarding the likelihood of any external intervention in case of a bank’s

default) (CGFS, 2011). Alternatively, Abbassi et al. (2016) proxy implicit guarantees with a

bank ownership dummy.

Internationalization and Debt Crisis

©2020 Korean Securities Association 301