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A framework to analyse the sovereign credit risk exposure of financial institutions

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  • Lewis, Jide

Abstract

Government and banking activities can be closely intertwined so that instability in one entity can spread contagiously to the other. This paper develops an integrative dynamic framework to evaluate the exposure of banks to sovereign credit risk using stress tests. The framework incorporates three main types of agents: banks, a government, and a rating agency where both the banking agent and the government agent can default on their financial obligations. Both banks and the government agent are subject to cognitive biases and use heuristics to make their decisions. The measures of macro-financial stability evaluated in the framework are the time-path of the external debt ratio, the probability of sovereign default, the fiscal balance and the bank's capital adequacy ratio. The framework is used to replicate the historical twin-crisis dynamics that ensues when stress tests are implemented on selected macro-financial variables, based on a perfect foresighting exercise for the case of Jamaica.

Suggested Citation

  • Lewis, Jide, 2015. "A framework to analyse the sovereign credit risk exposure of financial institutions," Journal of Risk Management in Financial Institutions, Henry Stewart Publications, vol. 8(2), pages 130-146, March.
    • Handle: RePEc:aza:rmfi00:y:2015:v:8:i:2:p:130-146
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    More about this item

    Keywords

    stress testing; sovereign debt crises; feedback; bank failure; twin sovereign and banking crises;
    All these keywords.

    JEL classification:

    • G2 - Financial Economics - - Financial Institutions and Services
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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