The Rise of Sovereign Risk

Financial Institutions should prepare for more country risk problems.

The global economy is now facing threats on several fronts. The most immediate danger relates to the continued deterioration in credit quality of many of the world’s sovereigns. During the 25-year “Great Moderation” that ended with the onset of the financial crisis in 2007, sovereign risk was perceived to have been eliminated and the idea that a large developed nation could default on its financial obligations seemed far-fetched.

When the global financial crisis hit, government-led bailouts of the financial system combined with the need for increased public spending quickly took its toll on the credit-worthiness of the world’s leading economies. Now, no sovereign can be considered truly risk-free—in fact, the whole concept of risk-free is starting to lose its meaning.

By bailing out the problems of insolvent institutions at the micro level, the various risk sources have now been aggregated to a macro level, resulting in the level of systemic risk increasing dramatically. The focus of analysts and risk managers has therefore shifted from the analysis of individual companies to the analysis of macro-level and systemic risks. As such, the level of correlation across asset classes has increased dramatically, with the value of most investments being predominantly driven by a small number of systemic factors: the risk of a hard landing in China, instability in the Eurozone, and the likelihood that central bankers might pump more money into the system via quantitative easing.

More broadly, sovereign debt concerns remind financial institutions about the reality of “country risk” and the need to measure and manage it. Unfortunately, perhaps as a result of the recent experience of a long period without any sovereign problems, few financial institutions are well prepared to cope with the re-emergence of country risk.

Fortunately, country risk is not a new phenomenon. Reflecting on the various debt crises that preceded the recent period of stability, it is clear that there is valuable experience in the industry that can be built upon and many financial institutions do at least have a country risk framework in place. The nature of today’s global economy, the proliferation of complex financial instruments, and the complicated nature of issues surrounding the Eurozone crisis means that these frameworks will, however, need to be extended if they are to cope with the scale of the country risk problems which appear to be coming down the pipeline.

The Rise of Sovereign Risk