Sovereign Risk in Macroprudential Solvency Stress Testing

Abstract

This paper explains the treatment of sovereign risk in macroprudential solvency stress testing, based on the experiences in the Financial Sector Assessment Program (FSAP). We discuss four essential steps in assessing the system-wide impact of sovereign risk: scope, loss estimation, shock calibration, and capital impact calculation. Most importantly, a market-consistent valuation approach lies at the heart of assessing the resilience of the financial sector in a tail risk scenario with sovereign distress. We present a flexible, closed-form approach to calibrating haircuts based on changes in expected sovereign defaults affecting bank solvency during adverse macroeconomic conditions. This paper demonstrates the effectiveness of using extreme value theory (EVT) in this context, with empirical examples from past FSAPs.

2021 Financial Sector Assessment Program Review—Background Paper On Quantitative Analysis

“…Most FSAP stress tests have treated sovereign risk as market risk from valuation changes in sovereign securities (Jobst and Oura, 2019). These stress tests face important challenges:…”

“…As a result, the same sovereign exposures could be valued or provisioned differently depending on how they are labeled. For instance, banks do not need to apply market valuation to securities in the held-to-maturity account (Jobst and Oura, 2019). However, such smoothing could reduce the effectiveness of macroprudential stress tests in the face of a sudden jump in sovereign risk.…”

“…The increased debt burden could increase sovereign risks in the years to come. As discussed by Jobst and Oura (2019), "sovereign distress" in EMDEs is more likely to be outright default than those experienced by advanced economies including explicit default on external debt, monetization of domestic debt, elevated bank loans to governments with evergreening, and accumulation of arrears among others. Indeed, the unprecedented unconventional monetary policy adopted by many EMDEs poses new challenges to assessing sovereign risks to financial stability in these jurisdictions.…”