Sovereign Risk is Risk

“If we take a long-term perspective, sovereign risk pricing in financial markets follows a well known pattern: we observe long periods of complacency during which risk premia and risk perceptions are unusually low while risks are building up. These periods of complacency are followed by sudden changes in market sentiment, which are both too abrupt and too late. A prolonged period of risk underpricing, reflected in excessively compressed spreads, corrects in a dramatic widening of credit spreads. Market discipline works spasmodically rather than consistently. It cannot be relied upon to foster fiscal rectitude.”

“Highly rated sovereigns are still low-risk assets but they are no longer perceived as risk-free, they are no longer zero credit risk assets.”

“In terms of risk management, it is important to distinguish between credit risk (default risk) and credit spread risk. Credit risk reflects the risk of potential credit losses due to a counterparty default event (default risk), or a credit migration event (a downgrade from one rating grade to another) or a country transfer event. Credit spread risk, which is part of the market risk incurred by a bank, reflects the market risk due to fluctuations in daily credit spreads (assuming no rating change) as distinct from the credit risk arising from a rating downgrade.”

“The rise in sovereign risk incurred by banks is also reflected in the volume of banks’ sovereign exposures. Since 2005, the BIS has compiled comprehensive data on national banking systems’ exposure to sovereign borrowers on an ultimate risk basis, which take into account guarantees and other off-balance sheet exposures. Such exposures include not only cross-border exposures but also the local claims on governments of subsidiaries of foreign banks. But, and this is an important limitation, banks’ claims on their home sovereigns are not included, although they often represent the major part of banks’ sovereign exposure.”

“The global sovereign debt crisis has exposed fault lines in the regulatory treatment of sovereign risk. However, the deficiency is not in the Basel standards but in the way the global standards have been applied in some countries and especially in the European Union. But, as mentioned earlier, the main anomaly with hindsight remains how complacently sovereign risk was priced by financial markets in the decade up to 2009. At most, European regulation especially the zero risk weight assigned to sovereign exposure may have encouraged a complacent assumption among market participants that a “euro area umbrella” existed.”

“…zero risk weight is applied to AAA and AA- rated sovereigns. The chairman of the IASB is said to have gone so far as to call this the “biggest accounting scam in history”.”