Argentina's financial sector is the most at risk of defaulting as the global economic fallout from the coronavirus pandemic collides with the country's prolonged recession and yet another sovereign debt crisis, S&P Global Market Intelligence data shows.

The median probability of default for public Argentine companies that operate mainly in the financial sector has skyrocketed in recent months to about 45% as of May 21 from 19% at the start of the year and about 8% a year ago.

To be sure, the pandemic and sovereign debt issues have weighed on the entire Argentine economy, which is expected shrink by up to 7% this year. The probability of default jumped to nearly 30% in most sectors, from between 9% and 17% a year ago. But the jump in risk for the financial space, which until recently had the lowest probability of default across sectors, has been especially pronounced. It now sits more than 15 points higher than the consumer discretionary space, which has led probability of default charts in many other geographies during the coronavirus pandemic.

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It is a trend unique to Argentina's financial sector. In other major Latin American countries such as Brazil, Chile and Mexico, for instance, market signals still suggest a median chance of default below 5% for financial companies.

Experts attributed the increased risk in Argentina in part to banks' intrinsic link with the sovereign, which has been in restructuring talks with creditors for months and recently failed to make $503 million in bond interest payments. Fitch Ratings on May 26 downgraded the country to restricted default after the missed payments.

"The sector has a very direct link with the sovereign that is not so evident with other corporates," Alejandro Garcia, Latin America bank director with Fitch Ratings, said in an interview. "A bank is almost always bonded to one country in particular and has exposure to the public sector by way of loans and government holdings."

Although banks have relatively small direct exposures to government debt, they do have considerable holdings with Banco Central de la República Argentina. Faced with rampant inflation and heightened credit risks, banks have increased their holdings of Leliqs, a 28-day bill issued by the central bank to banks, by 58.2% since the start of the year to about 1.202 trillion pesos as of mid-May.

The instruments historically have carried high yields with little to no risk. But given the level of strain the Argentine government is now under, it is "unclear" what will happen with those notes in the future, said Cynthia Cohen Freue, a senior director for financial services at S&P Global Ratings.

"There are a lot of things that the government could do in a highly stressed situation that would affect [banks] much more than the rest of the companies," she said. "They have a complex future."

Among the chief concerns for banks in the current environment is that the Argentine government could unilaterally extend the maturity of its debt as it has done in the past. Experts noted that such an extension with Leliqs is not in their base case scenario, but it is certainly in the realm of possibility.

If this were to happen, "banks would wind up short of liquidity to meet depositors' demand," said Ezequiel Zambaglione, Balanz Capital's head of research.

Pandemic pressure

The government also has been pushing banks to play a leading role to support Argentina's economy during the coronavirus pandemic. "We need greater support from banks," Matias Kulfas, the country's minister of production, said in late March.

Since then, lenders have been pushed into riskier small and medium-sized enterprise lending to support the government's effort to mitigate the impact of lockdown measures to control the virus's spread. At the same time, the government has installed interest rate caps that have challenged lenders' profitability.

The measures put further strain on a banking system that is broadly undersized. While Argentina is the region's third-largest economy, total banking industry assets stand at just $112.35 billion, less than half the total in Colombia, the region's No. 4 economy, and about a quarter of the total in Chile, the No. 5 economy.

"Any regulation that forces banks to make decisions that they would not have made themselves quite possibly adds more risks to the system," Zambaglione said. "If they are forced to lend to SMEs in trouble, then delinquencies will rise and solvency ratios will stress out."

As of May 27, US$1 was equivalent to 68.35 Argentine pesos.