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

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.