Sovereign and Financial-Sector Risk: Measurement and Interactions

Abstract

The complex spillover effects between sectors observed during the global financial crisis and recent European crisis make clear the importance of improving our understanding of the interactions and feedback mechanisms between sovereign and banking-sector risks. To that end, this paper presents a conceptual framework for analyzing the sovereign, banks, and their interlinkages based on contingent claims analysis (CCA). Our bank-by-bank framework uses balance-sheet data plus high-frequency market data in a way that measures risk exposures and can capture key risk transmission and feedbacks with the sovereign in real time. Risk transmission between banks and sovereigns can arise in the framework from several important sources: (a) bank holdings of risky sovereign debt, (b) explicit and implicit guarantees from sovereigns to banks, and (c) spillovers from sovereign spreads into bank borrowing costs. We illustrate the framework with several examples and ways forward to analyze multicountry sovereign and banking interactions.