Does the Banking Sector Affect Sovereign Risk

Abstract:     
We examine the effects of liquidity in the banking system (proxy for financial sector sophistication) and the degree of competition in the banking sector within a nation on sovereign risk. We hypothesize that more competitive and sophisticated financial systems will be less prone to panics or bank runs, and, consequently, be associated with superior sovereign credit ratings. Using Ordered Probit with Aggregate Time Effects methodology, our results show that financial system variables such as Concentration in Banking System, Size of Financial System, and Liquidity of Banking Assets are significantly related to sovereign credit ratings. Since the use of these sovereign ratings is ubiquitous in international finance in varied applications such as determination of the cost of international borrowing by governments, international cost of capital for FDI, and others, the relationships identified in this paper have important public policy implications.

Keywords: Sovereign rating, banking concentration, liquidity

JEL Classification: F34

working papers series