Contingent Liabilities and Sovereign Risk: Evidence from Banking Sectors

Abstract

The recent financial crisis has underscored the importance of contingent liabilities for sovereign risk management. However, quantifying contingent liabilities remains a difficult task and, partly as a result, they continue to be recognized as a liability only when the contingency materializes. This paper proposes a simple analytical model to estimate contingent liabilities that arise from (implicit and explicit) government guarantees to the banking sector. In doing so, we model the banking sector as a portfolio of banks and the government as a portfolio manager that may need to cover expected and unexpected losses of such a portfolio. This standardized method allows us to construct cross-country estimates on potential costs of bank failures so that contingent liabilities from the banking sector can be better tracked and monitored. Furthermore, we use these estimates and the corresponding sovereign CDS spreads from 32 countries, to empirically test whether the contingent liabilities from the banking sector is a significant exploratory variable for the determination of sovereign risk. Our results suggest that a one percent of GDP increase in contingent liabilities is associated with an increase in sovereign CDS spreads of 24 basis points in advanced countries and 75 basis points in emerging economies.