Institutions and the sovereign-bank nexus in the MENA

Abstract

We examine the role of country-level institutional quality in influencing the interlinkages between sovereign debt and domestic banks, commonly referred to as the sovereign-bank nexus, in the MENA region. Using a panel of 13 MENA countries, we find that stronger institutional quality reduces reliance on domestic banks for sovereign debt. Stronger rule of law, regulatory quality, and control of corruption have the most significant effects in reducing domestic bank holdings of sovereign debt. Consistent with substitution between foreign and domestic creditors, we find that stronger institutional quality is associated with higher holdings of sovereign debt by foreign creditors, and lower holdings by domestic central banks. We also show that stronger institutional quality reduces domestic bank balance sheet exposures to sovereign debt. Our findings remain robust after addressing potential endogeneity concerns using a two-stage least squares (2SLS) approach using Lewbel (2012) instruments. Extending our analysis to a broader sample of 96 countries, our results continue to hold, with the impact of institutional quality being more pronounced in the MENA region. Our results highlight the critical role of institutional quality in mitigating the sovereign-bank nexus and enhancing financial stability in the MENA region.