Abstract
Abstract European countries have increased significantly their public debt since the Global Financial Crisis. The increasing trend and the high concentration of public debt in portfolios of financial institutions can lead to a financial turmoil we witnessed during the European Sovereign Debt Crisis. Financial stability authorities therefore look for models to measure the sovereign credit risk and develop“what-if”scenarios to assess a potential repercussion of a financial institution rescue or of an economic contraction on sovereign credit risk. The presented article introduces adjustments to the sovereign contingent claims analysis that is based on the Merton´s Credit Risk Model and the Black-Scholes option pricing techniques. The article proposes adjustments by introducing a new view on a stylised liability side of a central government balance sheet, seniority of its items, and a new proxy for risk measure of junior claims. We show reliable results using derived risk sensitivities for 20 EU countries with decent forward looking ability and propose potential stress-testing framework with an application for the Czech Republic.
Highlights
The government bond market is the largest in terms of issue volume, and the most liquid one
Sovereign credit risk is often regarded as the lowest risk in the economy
The specific position and concentration of these securities in banks' balance sheets are connected with central bank collateral policy and, in particular, with the preferential treatment given to government bonds in banking regulations on credit and liquidity risk (Bank for International Settlements, 2013)
Summary
The government bond market is the largest in terms of issue volume, and the most liquid one. We pioneered the method with focus on the stability of risk-adjusted economic balance sheet of a sole government and not the joint balance sheet of government and central bank, which opens the possibility of a sovereign default on a domestic currency debt. We believe that this kind of indicator can cover some of the effects which the standard linear indicators cannot, offering a complementary framework in the set of current models. We follow with a brief framework for a stress-testing that is applied for the Czech Republic
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