Sovereign risk, systemic risk, and financial system stability

The recent crisis demonstrated how rapidly financial distress can be transmitted to the domestic economy and across borders. Credit has played a key role in the transmission of financial distress to the broader economy, consistent with evidence from the literature. Indeed, studies by Gilchrist et al (2009), Marcucci and Quagliariello (2008), Jacobson et al, 2005, and Carlson et al (2008) show that the credit channel is the main channel of transmission of financial distress, the strength of which hinges on that of the financial accelerator—the extent to which borrowing costs depend on the external finance premium that reflects borrowers’ net worth (Bernanke and Gertler, 1995; Bernanke, Gertler and Gilchrist, 1999; and Kiyotaki and Moore, 1997).

This paper describes a framework for analyzing a country's exposure to macroeconomic risks, based on the theory and practice of contingent claims analysis( CCA). The CCA analysis is an integrated framework relating bank asset values to equity value, default risk, and bank funding costs.

The systemic contingent claims analysis (‘Systemic CCA’) framework helps quantify the magnitude of general solvency risk and government contingent liabilities by combining the individual risk-adjusted balance sheets of financial institutions and the dependence between them.

The Systemic CCA applied to the financial sector delivers useful insights about the magnitude of systemic losses and potential public sector costs from market-implied contingent liabilities. Stress tests using this framework will be presented.

The paper will provide new directions for a framework of integrated stress testing of banking and sovereign risk, with macrofinancial feedbacks, and monetary and fiscal policy analysis. Future research would ideally explore directions in using CCA-based economic output value and Systemic CCA to promote economic growth and financial stability, as well as the relationship to fiscal and debt management dynamics.