Sovereign Adaptive Risk Modeling and Implications for the Eurozone GREXIT Case

Morgan Escalera,Wayne Tarrant

doi:10.3390/ijfs6020048

Abstract

In the wake of the 2008 financial crisis, the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS) created a list of systemically important financial institutions (SIFIs) with the intention of determining which financial institutions were important enough to the global market that their failure would result in systemic collapse. In this work, we create a model that modifies the BCBS’s five indicators of size, interconnectedness, cross-jurisdictional activities, complexity, and substitutability and apply these measures of systemic stress to governments. Although the cross-jurisdictional activities and size were almost identical to the SIFI calculations, the others had to be adapted to mirror the intent of the BCBS. Interconnectedness is calculated by simulation of what would happen to nearby countries if a country defaulted. Substitutability is estimated by the number of services that would no longer be provided if the government ceased to exist. Complexity is market-based and is derived from credit default swap (CDS) spreads. The original application of the model was to track the systemic interdependence of the Eurozone, with particular emphasis on the case of Greece. We anticipate that this model can be used in regional fiscal situations beyond the Eurozone.

Highlights

The financial markets experienced some of the worst activity in recorded history during the global recession that began with the housing bubble crash in 2007
In order to combat this threat to global financial stability, the Financial Stability Board (FSB), along with the Basel Committee for Banking Supervision (BCBS), drafted a method to determine what constitutes globally systemically important banks (G-SIB), which changed in later reports to systemically important financial institutions (SIFI)
The LGD viewpoint measures how bad things can become when they become bad and the probability that things will reach a certain such level. This methodology was chosen by the BCBS because the intent of systemic importance was an accounting of the systemic risk of the financial institution should a crisis already be underway and the probability of going into crisis (Basel Committee on Banking Supervision 2013)

Summary

Introduction

The financial markets experienced some of the worst activity in recorded history during the global recession that began with the housing bubble crash in 2007. In order to combat this threat to global financial stability, the Financial Stability Board (FSB), along with the Basel Committee for Banking Supervision (BCBS), drafted a method to determine what constitutes globally systemically important banks (G-SIB), which changed in later reports to systemically important financial institutions (SIFI). The LGD viewpoint measures how bad things can become when they become bad and the probability that things will reach a certain such level This methodology was chosen by the BCBS because the intent of systemic importance was an accounting of the systemic risk of the financial institution should a crisis already be underway and the probability of going into crisis (Basel Committee on Banking Supervision 2013). While both the FSB and BCBS are purely advisory bodies, many of the largest nations in the world have adopted their guidance into law

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