Investment Banks’ Behavior and Sovereign Debt Crises

Bond market
Sovereign debt
Financial Economics

While there is much research analyzing how emerging market economies access the international bond market, studies of the formation of prices in the emerging sovereign bond market are rare and tend to focus on the incidence of the pricing of certain covenants, such as collective action clauses. This stands in contrast to the massive literature on the determinants of underwriting fees in the primary corporate market of developed countries.

A recent study (Nieto-Parra 2009) analyzes sovereign debt crises through the prism of the primary sovereign bond market and describes the behavior of and interactions among its principal actors before and after a sovereign debt crisis. The study finds that investment banks price sovereign default risk well before investors can detect it and before crises occur.

Behavior of Investment Banks in the Primary Market 

Aside from the role as intermediaries between issuers and investors, one of the most important responsibilities of underwriters is to promote the bond. The activities of dissemination and promotion involve effort and risk for investment banks acting as underwriters. The first and foremost risk concerns the potential loss of reputation in the event of government default. Historically, the reputation of underwriters has affected the behavior of investors (Flandreau et al. 2010). In regard to the corporate market, reputable banks charge higher fees, which can be interpreted as economic rents on reputation (Hua Fang 2005).

Besides the reputation risk, investment banks face other risks related to the transaction itself. Even if most bonds are now placed with a “best efforts” contract—in which investment banks pledge to help find customers but are not forced to acquire any bonds in the absence of buyers—investment banks can incur some risks. First, they need to buy the issue before selling it on to the investors and thus face a “settlement risk” during the “book-building” process. Second, investment banks have the responsibility to place the bonds in the market and make an effort to stabilize the price of the bonds in the secondary market for an unspecified time. 

Because of these efforts and risks, investment banks are likely to charge fees that are positively correlated with the probability of a debt crisis. But why do investment banks have more information than investors? The answer has to do with the fact that underwriting involves a close, regular, and often privileged relationship with important actors in government (e.g., treasury, ministry of finance). As pointed out by one of the investment banks interviewed for that research, “The information you get from underwriting is very important—not insider information, but a lot of knowledge on what a sovereign –government- tends to do.”

Although public information to distinguish high default risk countries from other emerging economies is available (at least ex post), investment banks could be more concerned about these aspects than investors. In fact, research shows that investors tend to herd and may have weak incentives to learn about individual countries (Calvo 1998). One way to show that herding is more important for investors than for investment banks is to regress the risk perception of investors (the primary bond spread) and that of investment banks (the fee) against a variable that measures external market conditions (VIX Index). The finding is that the fit of the investors’ regression is higher than that of the investment banks’ regressions, which is consistent with the idea of more herding by investors. 

Underwriting Fees and Bond Spreads Around Debt Crises

Figure 1 shows the average annual fee and primary sovereign bond spreads for a sample of 436 bond issues in the period 1993-2006 and covering twenty-nine emerging economies. Squares indicate the fee and bond spreads between three (T-3) and one (T-1) year before the onset of a crisis. Fees are substantially higher (given the bond spread) for countries that will eventually suffer a crisis, relative to other emerging economies. On average, countries facing a significant sovereign default risk had to pay 1.1% of the amount issued to investment banks between one and three years before the onset of a crisis, almost twice the emerging countries’ average during the sample period (0.56%). By contrast, when the level of primary sovereign bond spreads between one and three years before a crisis is compared with respect to the total for emerging countries, it is found that the former is on average only slightly higher than the latter (385 basis points versus 319 basis points) and much lower than the primary sovereign spread at the onset of the crisis (603 basis points).

Figure 1. Fees and primary sovereign bond spreads
(1993-2006, annual basis)

In particular, between three and one years before a crisis, the component of the fee not explained by the spread is high and statistically significant (Figure 2), meaning that crisis governments pay investment banks more before a crisis (for example, 0.7% of the amount issued three years before the crisis). At the onset of the crisis (time T) and thereafter, the variable component of the fee is instead fully driven by other factors. This result confirms that as high default risk countries approach the onset of a crisis, the “information value” of the fees with respect to sovereign bond spreads decreases considerably and then completely disappears when the crisis actually takes place. It also shows that underwriting fees between three and one years before the crisis is significantly higher than in tranquil periods.

Figure 2. Fee and primary sovereign bond spread around sovereign debt crises (annual basis)

Underwriting Fees and Financial Markets Actors

The results suggest that investors do not make use of information about fees in pricing bonds. This finding was confirmed by a series of interviews with investment firms in which institutional investors were asked questions about their perceptions of the structure of the primary sovereign bond market. Seven investors out of the eight interviewed said that underwriting fees play no role in their investment decisions. Investors argued that because fees result from the connection between investment banks and governments, these are of no interest to them.

The survey and empirical results show that underwriting fees are not used as a tool in determining portfolio allocations. It is puzzling that useful, publicly available information (in Bloomberg or in Dealogic’s DCM Analytics databases) is not tracked by investors. This is directly connected with the study of the efficiency of sovereign bond markets. Why do investors not pay attention to the evolution of fees? It is possible that the sort of market inefficiency described in this column is driven by the phenomenon of “herding behavior.” Individual investors may not pay attention to useful public information because they are only concerned with the variables, which are considered “leading indicators” by the rest of the market. This is just another example of Keynes’s “beauty contest.”


As early as three years before entering a debt crisis, countries pay underwriting fees that are almost twice as high as the underwriting fees paid in the average emerging market economy. In contrast, sovereign bond spreads do not seem to be good leading indicators of debt crises. A crucial difference between the underwriting market of today versus that of the past is that, in the past, a signal of credit risk was the prestige of the underwriting bank responsible for placing the bond (Flandreau et al., 2010). Today, it would appear as though the fee contains more information about credit risk than a bank’s reputation.

Today, underwriting fees can be used as early warning indicators of debt crises, after controlling for standard economic variables. In addition, increases of the secondary sovereign bond spread could also be explained by the underwriting fee (Nieto-Parra, 2009).

These results show that underwriting fees provide valuable information. It is puzzling that investors do not use this potentially useful public information in order to allocate efficiently their portfolios of emerging-market, fixed-income assets. Should policymakers promote the dissemination of underwriting fees? If so, how can policymakers increase the use of this type of information by market participants? These questions do not have straightforward answers since they involve several trade-offs. Advertising the importance of underwriting fees and promoting their use may improve market efficiency, but it may also lead investment banks to adopt less transparent pricing schemes that would hide the information currently incorporated in the fees. Along similar lines, sovereign issuers with poor fundamentals would also have incentives to alter the fees in order not to be charged higher bond spreads.


Calvo, G. A. 1998. “Varieties of Capital Market Crises.” In The Debt Burden and Its Consequences for Monetary Policy, edited by G. Calvo and M. King, pp. 181–202. Basingstoke: Palgrave Macmillan.

Flandreau, M., J. H. Flores, N. Gaillard, and S. Nieto-Parra. 2010. “The End of Gatekeeping: Underwriters and the Quality of Sovereign Bond Markets, 1815–2007.” In NBER International Seminar on Macroeconomics 2009, edited by L. Reichlin and K. West. University of Chicago Press.

Hua Fang, L. 2005. “Investment Bank Reputation and the Price and Quality of Underwriting Services.” Journal of Finance 60 (6): 2729–61.

Nieto-Parra S. (2009),  Who saw sovereign debt crises coming?, Economía 10 (1), Fall 2009, pp. 125-169, Brookings Institution Press

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