sovereign risk - garpregulators appraisal of sovereign risk diverges from markets’ and rating...

Sovereign Risk

Shlomo M Cohen Institutional Advisor Global Association of Risk Professionals September 7, 2014 Tel-Aviv, Israel

2

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.

3 | ��© 2014 & + Shlomo M Cohen. All rights reserved.

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?


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?


Sovereign Risk Assessment Is Not Good Enough

Regulators appraisal of sovereign risk diverges from markets’ and rating agencies’ §  This is a serious issue because it impacts bonds valuations, which should reflect their risk

And markets and rating agencies appraisals are misaligned §  Spreads reacted strongly to the 2008 crisis, when ratings kept on improving

§  Then ratings dropped suddenly in 2011 and ignored the 2012 spreads recovery

BIS Papers No 72 xxiii

Welcom ing remarks

Jaime Caruana1

Let me extend a warm welcome to all the participants in this BIS sem inar on sovereign risk. In these brief introductory remarks, I would like to provide you with an outline of the sem inar and to pose some questions for the next day and a half. At the same time, I cannot resist an aside on the orig ins of cred it risk.

The Latin root of cred it is credere, the infinitive form of credo. John Maynard Keynes described cred it in 1943 as the “m iracle . . . of turning a stone into bread”. And cred it can indeed do great things, whether extended to sovereigns or to the private sector.

Recently, however, there has been too much of a good thing, contributing to a signal increase in system ic risk. As noted by the BIS Annua l Report last June, the poo l of top-rated sovereign debt within the OECD has d im inished considerab ly over the past few years and it has also become more concentrated by issuer (see burgundy-co loured area in Graph 1, right-hand panel below).

The sovereign cred it quality of advanced economies has deteriorated rap id ly over the past few years. And it will be d ifficult to improve that trajectory any time soon, g iven the modest outlook for growth, lingering frag ilities in the financial system and still high levels of private indebtedness. Over the past five years, pub lic debt in the advanced econom ies has jumped from about 75% of GDP to 110%, with 1 General Manager, Bank for International Settlements.

Cred it risk profile of the poo l of general government debt1

In trillions of US do llars Graph 1

CDS spreads-based Ratings-based2

1 Total outstand ing for OECD countries. The debt levels used are year-end observations. End-quarter observations are used for the CDS spreads and ratings. 2 The ratings used are simple averages of the foreign currency long-term sovere ign ratings from Fitch, Moody’s and Standard & Poor’s.

Sources: Bloomberg; Markit; national data; BIS calculations.

0

10

20

30

40

01 02 03 04 05 06 07 08 09 10 11 12Above 200 bp150–200 bp

100–150 bp50–100 bp

Below 50 bpOther assets (unclassified)

0

10

20

30

40

01 02 03 04 05 06 07 08 09 10 11 12Below AA–AA– to below AA

AA to below AA+ AA+ to below AAA

AAA

Source : Bloomberg, Markit, national data, BIS calculations



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



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.


Share of domestic sovereign bonds held

by domestic banks

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


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


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

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

Sovereign crisis Financial Institutions

Government bonds lose value

Outflow of deposits from the country

Tax increase, possibly on deposits

Cascading of country’s rating downgrade

Economic actors affected by slowdown

Temptation to use regulation to favor domestic sovereign bonds


This Generalized Exposure To Sovereigns Creates A Systemic Risk

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 §  “Oxygen” concern

The reinforcing dependency between banks and the States amplifies the systemic risk §  This is particularly true in southern Europe

–  Italian banks exposure to Eurozone sovereigns increased +60% in 2012 to 412bn€

–  And Spanish banks exposure reaches 283bn€

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.

4 Systemic Risk Survey 2013 H2

Worries about the risk of an economic downturn are downsignificantly since the previous survey (cited by 67% ofrespondents, down 12 percentage points). Risks to the globaland UK outlooks were equally prominent (each cited in 41% ofresponses which indicated a region). 6% of these responsescited Europe, 5% the United States and 3% emerging marketsand China respectively.

For the second survey in succession, risk surrounding the lowinterest rate environment was the fastest-growing category,with 43% of respondents citing it, up from 26% in theprevious survey. In allocating responses to different riskcategories, the definition of this risk has been broadened outto include risks associated with a snapback in low rates tomore normal levels as well as risks directly associated with lowrates.(1) Just over 40% of responses specifically referred to asnapback in rates, with a couple of these responses pointingtowards the potential impact of a sharp rise in interest rates onequity, property and credit markets. The remaining responsesreferred to risks associated with a prolonged period of lowinterest rates (for example, one specific response referred tothe impact of negative real interest rates on investmentbehaviour).

Risk around property prices has also risen further since theprevious survey, with 36% of participants citing the risk, up 11 percentage points since the previous survey. Concerns wereconcentrated almost exclusively on the residential market,where responses focused on the risk of a house pricecorrection, with several respondents citing the risk of a bubbleemerging in the near term.

Risks associated with regulation and/or taxes remained heavilycited, mentioned by 41% of respondents, up slightly on May 2013. The focus was on the potential negative impact ofregulation, including excessive, inconsistent, or overly complexregulation, as well as on a loss of confidence in regulation.

Risks most challenging to manage as a firmRespondents were also asked which three of the key risks theyhad listed would be most challenging to manage as a firm.Chart 6 presents the seven most cited risks, which remain thesame ones as in the previous survey.

Respondents indicated they would find six of the seven risksfrom Chart 4 the most challenging to manage. Risk aroundproperty prices does not appear in the top seven, indicatingthat this is perhaps easier to manage:

• Sovereign risk (56% of respondents).• Risk of an economic downturn (33%).• Risks around regulation/taxes (29%).• Risks surrounding the low interest rate environment (23%).• Operational risk (16%).• Risk of financial market disruption/dislocation (14%).• Risk of financial institution failure/distress (14%).

Chart 6 Risks most challenging to manage as a firm(a)(b)

0

20

40

60

80

100

2008 09

H1 H2 10

H1 H2 H1 H2 H1 H2 H1 H2

Per cent

Financial institution distress

Operational risk

11 12 13

Sovereign risk Economic downturn

Low interest rate environmentRegulation/taxes

Financial market disruption

Sources: Bank of England Systemic Risk Surveys and Bank calculations.

(a) After respondents had listed the five risks they believed would have the greatest impact onthe UK financial system if they were to materialise, they were asked which three of these risksthey would find most challenging to manage as a firm. Answers were in a free format andwere coded into categories after the questionnaires had been submitted; only one categorywas selected for each answer. Chart figures are the percentages of respondents citing a givenrisk at least once, among respondents citing at least one key risk. The chart shows the topseven categories only; see the data appendix for additional categories.

(b) Risks cited in previous surveys have been regrouped into the categories used to describe thelatest data.

0

20

40

60

80Per cent

Sovereign risk Economic downturn Low interest rate environmentRegulation/taxes

Property prices Financial institution distress Loss of confidence in authorities

2008 09

H1 H2 H1 H2 H1 H2 H1 H2 13

H1 H2 121110

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 onthe UK financial system if they were to materialise, in order of potential impact (ie greatestimpact first). Answers were in a free format and were coded into categories after thequestionnaires 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 sevencategories; see the data appendix for additional categories.

(b) Risks cited in previous surveys have been regrouped into the categories used to describe thelatest data.

Chart 5 Number one key risks to the UK financialsystem(a)(b)

(1) Previous survey responses have also been reclassified on this basis.


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??


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


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


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

Creating a culture of risk awareness®

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About GARP | The Global Association of Risk Professionals (GARP) is a not-for-profit global membership organization dedicated to preparing professionals and organizations to make better informed risk decisions. Membership represents over 150,000 risk management practitioners and researchers from banks, investment management firms, government agencies, academic institutions, and corporations from more than 195 countries and territories. GARP administers the Financial Risk Manager (FRM®) and the Energy Risk Professional (ERP®) Exams; certifications recognized by risk professionals worldwide. GARP also helps advance the role of risk management via comprehensive professional education and training for professionals of all levels. www.garp.org.

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