Sovereign Risk in Macroprudential Solvency Stress Testing

60 Pages Posted: 22 Jan 2020

See all articles by Andreas (Andy) Jobst

Andreas (Andy) Jobst

International Monetary Fund (IMF) - European Department

Hiroko Oura

International Monetary Fund (IMF)

Date Written: December 2019

Abstract

This paper explains the treatment of sovereign risk in macroprudential solvency stress testing, based on the experiences in the Financial Sector Assessment Program (FSAP). We discuss four essential steps in assessing the system-wide impact of sovereign risk: scope, loss estimation, shock calibration, and capital impact calculation. Most importantly, a market-consistent valuation approach lies at the heart of assessing the resilience of the financial sector in a tail risk scenario with sovereign distress. We present a flexible, closed-form approach to calibrating haircuts based on changes in expected sovereign defaults affecting bank solvency during adverse macroeconomic conditions. This paper demonstrates the effectiveness of using extreme value theory (EVT) in this context, with empirical examples from past FSAPs.

Keywords: Financial crises, External sector, Financial markets, Financial institutions, Financial instruments, FSAP, macroprudential, sovereign risk, stress testing, valuation haircut, WP, discounted cash flow, AfS, default risk, country-specific, CDS

JEL Classification: G12, G21, G28, E01, K2, M41

Suggested Citation

Jobst, Andreas A. and Oura, Hiroko, Sovereign Risk in Macroprudential Solvency Stress Testing (December 2019). IMF Working Paper No. 19/266. Available at SSRN: https://ssrn.com/abstract=3523139

Andreas A. Jobst (Contact Author)

International Monetary Fund (IMF) - European Department ( email )

700 19th Street NW
Washington, DC 20431
United States
+1-202-538-2898 (Phone)

Hiroko Oura

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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