DDEP: Maintaining financial stability spill overs: Lessons learned and best practices

Introduction

Ghana’s domestic debt exchange program (DDE) can have significant implications for financial institutions, particularly banks and non-bank financial institutions, and can pose challenges to financial stability. The potential impact on banks' balance sheets and earning potential, as well as the risk of capital shortfalls and liquidity pressures, requires careful planning and management to minimize the impact on financial stability.

In addition, the DDEP must be calibrated to ensure that it does not impede the central bank's ability to conduct its main functions. This may involve the establishment of a financial sector stability fund to provide liquidity support and enhance investor confidence.

In this context, several measures, such as mark-to-market valuation, recognition of losses, and restoration of capital buffers, may be necessary to address potential losses on sovereign exposures.

This article explores the challenges associated with a sovereign domestic debt restructuring and examines strategies for managing these challenges in a way that promotes financial stability while limiting fiscal risks spill overs.

There are several examples of sovereign debt crises that have led to financial sector crises in other countries. For instance, the Greek sovereign debt crisis in 2010 resulted in significant losses for Greek banks that held large amounts of Greek government debt. As a result, the Greek banking system experienced severe liquidity pressures and a loss of confidence, leading to a broader financial sector crisis.

Similarly, the Argentine sovereign debt crisis in 2001-2002 resulted in a significant banking crisis due to the exposure of Argentine banks to government debt. The crisis led to a run on banks, massive withdrawals of deposits, and widespread banking system failures.

In both cases, the sovereign debt crisis led to a loss of confidence in the financial system, triggering a banking crisis that required significant government intervention to restore stability.

Direct Operational Challenges

1. Capital flight and the attendant effects on the net international reserves position: Capital flight occurs when investors and savers withdraw their funds from a country, which can put pressure on the country's net international reserves. If this occurs, financial institutions that hold significant foreign currency assets may experience losses due to the depreciation of the domestic currency. This can negatively impact their balance sheets and reduce their capacity to lend.

2. Margin calls or withdrawal of foreign credit lines triggered by a sovereign rating downgrade, requiring topping up of the collateral or repayment: If a country experiences a sovereign rating downgrade, foreign investors may reduce their exposure to the country's financial institutions. This can lead to margin calls or withdrawal of foreign credit lines, which may require the financial institution to top up the collateral or repay the loan. This can put pressure on the institution's balance sheet and potentially limit its lending capacity.

3. Exchange rate depreciation pressures driven by a run to safety or increased demand for foreign currency to meet margin calls: A run to safety occurs when investors flee from domestic assets and currencies in favour of safer foreign assets and currencies. This can put pressure on the domestic currency, causing it to depreciate. Financial institutions that hold significant foreign currency assets may experience losses due to the depreciation of the domestic currency, reducing their capacity to lend.

4. Loss of ability to access the central bank's normal liquidity facilities due to limited eligibility of restructured assets as collateral: If financial institutions are holding restructured assets, they may no longer be eligible to use them as collateral to access the central bank's normal liquidity facilities. This can put pressure on their liquidity position and limit their lending capacity.

5. Rapid decline in asset values driven by fire sale of assets and deleveraging by banks: If financial institutions face a rapid decline in asset values, they may be forced to sell assets quickly to raise cash. This can trigger a fire sale of assets, further depressing asset values and potentially leading to a systemic crisis. Additionally, if banks engage in deleveraging by reducing their exposure to risky assets, this can reduce their lending capacity and put pressure on their balance sheets.

6. Spill overs due to ownership and financial interlinkages with affected financial institutions (i.e., among banks, insurance companies, investment funds, etc.): Financial institutions are often interconnected through ownership and financial linkages, such as through loans and derivatives and investment contracts. If one institution experiences financial distress, it can lead to spillover effects on other institutions, potentially causing a systemic crisis. This can put pressure on the balance sheets of affected financial institutions and reduce their lending capacity.

Managing the Impact on the Banking System

Regulatory Forbearance

Regulatory relief measures refer to actions taken by regulatory authorities to temporarily relax or ease certain regulations or requirements imposed on financial institutions. These measures are intended to reduce the burden on financial institutions during times of economic stress, such as a sovereign debt restructuring, and to help them maintain their capital adequacy and liquidity. However, in the case of a debt reprofiling, regulatory relief measures to reduce the impact on banks' capital should be avoided. This is because such measures may undermine the credibility of the banks' reported figures and delay appropriate mitigating actions.

For example, if regulatory authorities relax capital requirements during a debt reprofiling, banks may appear to have sufficient capital when in fact they are exposed to significant risks. This can mislead investors and regulators, and delay necessary corrective actions to address the underlying problems. Similarly, if liquidity requirements are relaxed, banks may become overly reliant on short-term funding, which can be volatile and unstable, increasing the risk of a systemic crisis.

Furthermore, regulatory relief measures can create moral hazard, whereby banks take excessive risks, knowing that regulatory authorities will provide relief in the event of a crisis. This can lead to a build-up of systemic risks and increase the likelihood of a financial crisis.

A financial sector stability fund, as announced, may support bank liquidity and investor confidence.

A financial sector stability fund is a fund set up to provide liquidity support to the banking system during times of financial stress or crisis. It can be funded by the government, the central bank, or by international financial institutions (IFIs).

During a sovereign Domestic Debt Restructuring (DDR), the banking system may come under pressure due to factors such as capital shortfalls, liquidity problems, and depositor withdrawals. A financial sector stability fund can help to address these issues by providing liquidity support to banks, thereby reducing the risk of systemic instability.

By providing a backstop to the banking system, a financial sector stability fund can also enhance investor confidence, which is critical for maintaining financial stability during a DDR. This can help to prevent a panic or run on banks, which can exacerbate the situation and lead to wider economic disruption.

International financial institutions (IFIs), such as the International Monetary Fund (IMF) and the World Bank, can provide support to financial sector stability funds by providing funding, technical assistance, and policy advice. This can help to strengthen the effectiveness and credibility of the fund, and increase its ability to support the banking system during times of stress.

If losses cause regulatory bank capital shortages, losses must be recognized, and capital buffers restored.

When a bank suffers losses, it may need to recognize those losses on its financial statements. The recognition of losses reduces a bank's net worth, which in turn can affect its capital adequacy ratios. If losses are significant enough to cause a shortfall in regulatory capital, the bank may be in violation of regulatory requirements.

In such a scenario, recognizing the losses is only the first step. The bank also needs to develop a strategy to restore its capital buffers. This is important because capital buffers provide a cushion against unexpected losses and help to maintain the bank's financial stability.

The strategy to restore capital buffers can take various forms, depending on the severity of the losses and the bank's financial position. Some options include raising new capital, selling assets, reducing expenses, and retaining earnings. The appropriate strategy will depend on factors such as the bank's financial strength, market conditions, and regulatory requirements.

It is important for banks to act promptly in developing a strategy to restore their capital buffers. Delaying this process can prolong the impact of the losses and increase the risk of a more severe financial crisis.

Additionally, restoring capital buffers may involve some trade-offs, such as reducing dividends or limiting growth, which can be difficult decisions for bank management and shareholders.

Bank of Ghana should urge banks to accurately measure and immediately recognize government exposure losses.

Enforcement of mark-to-market (MtM) requirements should be maintained for held-for-trading or fair value portfolios, even for new securities issued in a debt exchange, if their market valuation remains below par immediately after the exchange.

This ensures that most of the losses from the debt exchange are already accounted for, as markets would have priced in the likelihood of a restructuring. Additionally, expected losses on sovereign exposures should be measured and recognized through impairment, including those held at amortized cost.

In previous cases of reprofiling in some countries, MtM valuation was gradually phased in to smooth the impact of price volatility of sovereign debt securities around the exchange on bank capital. If regulatory treatment of sovereign exposures, such as higher risk weights and provisioning requirements, became stricter after a default or during pre-emptive debt negotiations, these treatments may gradually be phased out depending on the improved creditworthiness of the sovereign following the debt exchange.

The capital shortage must be rectified if banks' capital buffers cannot handle Significant losses and economic shocks.

Depending on the magnitude of the capital shortfall, the stability of troubled banks, and the possible systemic risk of their liquidation, the available solutions will differ. The initial phase should consist of accurately calculating capital deficiencies through a comprehensive asset quality review procedure.

Although there is no conventional design for such an exercise, an asset quality review (AQR) is frequently a critical component that may be reinforced by stress testing and scenario analysis.

During a debt restructuring, eliminating bank capital deficiencies must be carefully planned to preserve financial stability and avoid fiscal risks. The strategy to address shortfalls in bank capital during a domestic debt restructuring must be carefully crafted to promote financial stability and minimize fiscal risks. This is a challenging task due to the interconnected nature of the financial system and the potential spillover effects of any actions taken.

It is important to ensure that the solution does not create new financial stability risks, such as causing a loss of confidence in the banking system or triggering further capital outflows. At the same time, the solution must also limit fiscal risks, such as a potential increase in government debt or liability.

Given the complex nature of these issues, designing an effective strategy to address capital shortfalls in the context of a domestic debt restructuring requires a thorough understanding of the interplay between various factors, including macroeconomic conditions, market dynamics, regulatory frameworks, and government policies.

Prior to the DDEP, bank resolution frameworks should be in place. Bank resolution frameworks refer to the set of policies and procedures that are put in place to address the potential failure of a bank in a way that minimizes the impact on the broader financial system. These frameworks typically include a range of measures, such as early intervention, deposit insurance, and central bank liquidity assistance.

In the context of a debt restructuring, it is important to identify any gaps or weaknesses in these frameworks ahead of time. This allows policymakers to take steps to address these issues and ensure that the necessary tools and mechanisms are in place to deal with potential problems that may arise.

The IMF's Institutional Perspective suggests interim capital flow management measures (CFMs) on outflows after a debt restructure to protect financial stability from unexpected and rapid capital flight.

Sudden and rapid capital flight can occur when investors withdraw large amounts of funds from a country's financial system due to fears of economic instability or uncertainty. This can lead to a depletion of foreign reserves, a depreciation of the local currency, and potentially a financial crisis.

Debt restructuring, which involves changing the terms of a country's outstanding debt, can be one trigger for such capital flight. In order to prevent or mitigate the negative consequences of sudden capital outflows, temporary capital flow management measures (CFMs) on outflows may need to be considered.

CFMs on outflows refer to policies or regulations implemented by a country's government or central bank to limit the amount of capital that can be transferred out of the country by investors.

Examples of CFMs on outflows may include the imposition of capital controls, taxes on foreign transactions, or limits on the amount of foreign currency that can be purchased. The International Monetary Fund (IMF) recognizes that in certain circumstances, temporary CFMs on outflows may be necessary to safeguard financial stability.

This is reflected in the IMF's Institutional View on the Liberalization and Management of Capital Flows, which acknowledges that "there may be circumstances in which capital flow management measures are needed to achieve a well-defined policy objective, and that these measures can be consistent with a country's broader liberalization objectives."

Conclusion

In conclusion, Ghana’s domestic debt exchange (DDE) would have significant implications for financial institutions, particularly banks, and would pose challenges to financial stability. It is important to design a strategy for addressing potential capital shortfalls and liquidity pressures in a way that minimizes fiscal risks and maintains financial stability.

This may involve identifying and addressing gaps in early intervention, resolution, deposit insurance, and central bank liquidity assistance frameworks prior to the DDE. It is also important to ensure that the DDE is calibrated to minimize the impact on the central bank's ability to conduct its main functions.

Measures such as mark-to-market valuation, recognition of losses, and restoration of capital buffers may be necessary to address potential losses on sovereign exposures.

Additionally, the establishment of a financial sector stability fund, possibly supported by international financial institutions like the IMF and the World Bank, can help provide liquidity support to the banking system and enhance investor confidence over the period of DDEP.