Sovereign Risk
Shlomo M Cohen
Institutional Advisor
Global Association of Risk Professionals
September 7, 2014
Tel-Aviv, Israel
The views expressed in the following material are the
author’s and do not necessarily represent the views of
the Global Association of Risk Professionals (GARP),
its Membership or its Management.
2
Pitch
Sovereign risk is different from other credit risks
Sovereign risk assessment is not good enough
Still, the exposure of financial institutions to sovereign risk is increasing quickly
A key motive for this evolution is regulatory incentive
Financial institutions exposure to sovereign risk is intense and complex
This generalized exposure to sovereigns creates a systemic risk
How to recover from this unprecedented situation?
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Why Is Sovereign Risk Different From Other Credit Risks?
Although historically perceived as less risky as other economic actors, sovereigns
are in fact more risky.
Less consequences in case of default
§  When a corporation defaults, it vanishes.
§  When a sovereign defaults, basically nothing changes
–  Has Ireland sunk?
Paradoxically, a country that defaults will often feel better
§  Defaulting is a common solution to deal with crises
§  In the last 2 centuries, ALL countries but 14 (including Israel) have defaulted at least once
–  Spain has defaulted 13 times
Also, sovereign risk is under-estimated by prudential authorities
§  A country rated AA- or better cannot default, only be downgraded …. in which case it may default
§  Concentration and long maturities risks are ignored
§  Is there a conflict of interest?
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Sovereign
The Latin root of credit is credere , the infinitive form of credo. John Maynard
Keynes described credit in 1943 as the “miracle . . . of turning a stone into bread”.
And credit canIsindeed
do great
things, whether extended to sovereigns or to the
Risk Assessment
Not Good
Enough
private sector.
Recently, however, there has been too much of a good thing, contributing to a
Regulators appraisal
of sovereign
risksystemic
diverges
from
agencies’
signal
increase in
risk.
As markets’
noted byand
the rating
BIS Annual
Report last June, the
pool
of top-rated
sovereign
debt within
theshould
OECDreflect
has diminished
considerably over
§  This is a serious issue
because
it impacts
bonds valuations,
which
their risk
the past few years and it has also become more concentrated by issuer (see
burgundy-coloured
area in are
Graph
1, right-hand panel below).
And markets and rating
agencies appraisals
misaligned
§  Spreads reacted strongly to the 2008 crisis, when ratings kept on improving
1
Credit
profile
of thesuddenly
pool ofingeneral
government
§  Thenrisk
ratings
dropped
2011 and
ignored the debt
2012 spreads recovery
In trillions of US dollars
Graph 1
Source : Bloomberg, Markit, national data, BIS calculations
Ratings-based 2
CDS spreads-based
01
02
03
04
Above 200 bp
150–200 bp
1
05
06
07
08
100–150 bp
50–100 bp
09
10
11
12
Below 50 bp
Other assets
(unclassified)
40
40
30
30
20
20
10
10
0
0
01
02
03
04
05
Below AA–
AA– to below AA
06
07
08
09
10
AA to below AA+
AA+ to below AAA
11
12
AAA
Total
outstanding
OECD
countries.
The debt levels used are year-end observations. End-quarter observations are used for the CDS
| © 2014
& + Shlomo Mfor
Cohen.
All rights
reserved.
2
spreads and ratings.
The ratings used are simple averages of the foreign currency long-term sovereign ratings from Fitch, M oody’s and
5
Sovereign Risk Assessment Is Not Good Enough
Rating methodologies across agencies are very similar and are largely based upon short
term indicators such as GDP
§  S&P uses 5 scores: political, economical, International, tax policy and monetary
§  Moody’s assesses economic and institutional strengths, adjusted to tax and events; 3 out of these 4
factors are related to GDP
Consequently the ratings of the three major agencies are very close…
§  Lasting discrepancies larger than 1 notch are very rare
…and they are also very unstable, confirming the short term vision
§  In the recent crisis, the average downgrade speed was 6 notches / year
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Sovereign Risk Assessment Is Not Good Enough
Consequently, and not surprisingly, external ratings of sovereigns have proven to be
misleading indicators.
In the prelude of the 2011 debt crisis, PIIGS countries had issued large amounts of debt
which, on average, was rated AA and will lose 24% of their value in a year
§  A level that most analyst would rank as quasi-default
§  With a reduction of value of 5% in a year, Spain 10 years bonds should be rated B.
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Still, The Exposure Of Financial Institutions To Sovereign Risk Is Increasing Quickly
Taking sovereign risk is not part of the business model of banks
§  Which is typically to finance economic actors that have no access to the financial markets
Still, from the onset of the crisis, European banks holding of sovereign bonds has kept increasing
§  In 2010, long term exposures to PIIGS only was 764bn€ for 91 European banks <source: EBA>
§  And these exposures were meant to be risk-free…
Between the end of 2011 and June 2013, the exposure of domestic banks to their domestic
sovereign has increased +13% in Europe <source EBA>
§  Sovereign debt size has increased +11% and the share held by banks has increased +2% to 68%
§  There are disparities across the countries, those more stressed hold a higher % of domestic debt
Share of domestic
sovereign bonds held
by domestic banks
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A Key Motive For This Evolution Is Regulatory Incentive
Regulations pushes up the demand for sovereign bonds
§  Basel 2-3 under-estimation of sovereign risk boosts their apparent profitability
§  Sovereign bonds are major enhancers of Basel 3 liquidity ratios; shortfall:
Monetary policy also favors sovereign bonds
§  The cheap LTRO funding is largely invested in sovereign bonds
§  Moreover eligible to EBC repo
With favorable regulatory incentives, the supply of sovereign bonds has flourished to meet
the rising demand
§  Government debt issuance raised from a 10-15% market share in 2000 to 35% in 2009
§  AAA issuance has increased from 20% in 1990 to more than 50% since 2009
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Financial Institutions Exposure To Sovereign Risk Is Intense And Complex
When a sovereign crisis occurs, it hits financial institutions with multiple impacts
§  With many scenarios ending up into snowballs
Government bonds lose value
Cascading of country’s rating downgrade
Outflow of deposits from the country
Sovereign crisis
Financial Institutions
Economic actors affected by slowdown
Tax increase, possibly on deposits
Temptation to use regulation to favor
domestic sovereign bonds
Cooling mechanisms have been set up in Europe; will they not spread the heat?
§  From early 2010 to June 2012, 72bn€ have fled from Greece, or 30% of the deposits
§  Simultaneously, the ECB has lent 55bn€ to Greek banks
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This Generalized Exposure To Sovereigns
Cumulative effects of sovereign risk lead to
systemic risk, a risk not well understood
Sovereign risk has become the number one key
risk in many countries
respondents, down 12 percentage points). Risks to the gl
and UK outlooks were equally prominent (each cited in 4
responses which indicated a region). 6% of these respon
Creates
A Systemic
Risk States and 3% emerging ma
cited Europe,
5% the United
and China respectively.
Chart 5 Number one key risks to the UK financial
system(a)(b)
Sovereign risk
Economic downturn
Low interest rate environment
Regulation/taxes
Property prices
Financial institution distress
Loss of confidence in authorities
Per cent
§  “Oxygen” concern
The reinforcing dependency between banks and
the States amplifies the systemic risk
80
60
§  This is particularly true in southern Europe
40
–  Italian banks exposure to Eurozone sovereigns increased
+60% in 2012 to 412bn€
–  And Spanish banks exposure reaches 283bn€
20
Considering that supervisory bodies are part of
the Sovereign Institutions, it is not surprising that
they have a soft spot regarding sovereign risk
§  It also helps refinancing sovereign debt, not a small
matter considering that sovereign risk is largely
unknown.
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0
2008
H1
09
H2
H1
10
H2
H1
11
H2
H1
12
H2
H1
13
H2
Sources: Bank of England Systemic Risk Surveys and Bank calculations.
(a) Respondents were asked to list the five risks they thought would have the greatest impact on
the UK financial system if they were to materialise, in order of potential impact (ie greatest
impact first). Answers were in a free format and were coded into categories after the
questionnaires had been submitted; only one category was selected for each answer.
Chart figures are the percentages of respondents citing a given risk as their number one
key risk, among respondents citing at least one key risk. The chart shows the top seven
categories; see the data appendix for additional categories.
How To Recover From This Unprecedented Situation?
Hoping that supervisor will correct the biases that induce financial institutions into buying
sovereign bonds is probably vain.
§  Under the pressure of the G20 and the European Commission, politics are going in the opposite direction.
An alternative is to improve the assessment of sovereign risk
§  Unfortunately, the classical PD-based models do not work
§  And public ratings and market-based assessments are very volatile
§  SO??
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How To Improve The Assessment Of Sovereign Risk?
A major difference in the way credit risk is assessed for sovereigns vs most actors is the type
of data used
§  For most actors, the main solvency indicators are in the balance sheet
§  For sovereigns, the main solvency indicators are GDP, unemployment, inflation, tax level,…; these are
short term budgetary indicators.
-> Why not assess sovereign risk by analyzing their balance sheets?
§  More and more countries publish it now under the incentive of the UN, IMF and OECD
§  Usable balance sheet figures are now published by a growing number of countries
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How To Improve The Assessment Of Sovereign Risk?
A Nation’s balance sheet point of view places sovereign debt under a new light
§  In a long term perspective, debt levels are more easily justified and managed
A balance sheet approach would give to the States a tool to manage successfully their long term
equilibrium
§  Education, Energy, Ecology, Health, Retirement
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Wrap Up
The current regulation reinforces the link between sovereign and financial institutions
The generalized exposure of financial institutions to sovereigns creates a systemic risk
The latter is all the more dangerous that sovereign risk is not properly assessed
Correcting actions should include:
- A reassessment of sovereign risk based upon their balance-sheets rather than GDP
- The appropriation by the States of ALM type of tools to manage long term equilibrium
Which might hopefully lead to:
- An appropriate assessment of sovereign risk by regulators
- And finally the acceptance by regulators of financial institutions own assessment of risks
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