Sovereign Risk in Macroprudential Solvency Stress Testing
60 Pages Posted: 22 Jan 2020
Date Written: December 2019
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: Suggested Citation