We estimate the pricing of sovereign risk for fifty countries based on fiscal space (debt/tax; deficits/tax) and other economic fundamentals over 2005-10. We measure how accurately the model predicts sovereign credit default swap (CDS) spreads, focusing in particular on the five countries in the South-West Eurozone Periphery (SWEAP: Greece, Ireland, Italy, Portugal, and Spain). Dynamic panel estimates of the model suggest that fiscal space and other macroeconomic factors are statistically significant and economically important determinants of market-based sovereign risk. However, risk pricing of the SWEAP countries is not predicted accurately by the model either in-sample or out-of-sample: unpredicted high spreads are evident during global crisis period, especially in 2010 when the sovereign debt crisis swept over the periphery area. We “match” the periphery group with five middle income countries outside Europe that were closest in terms of fiscal space during the European fiscal crisis. SWEAP default risk is priced much higher than the “matched” countries in 2010, even allowing for differences in fundamentals. One interpretation is that these economies switched to a “pessimistic” self-fulfilling expectational equilibrium. An alternative interpretation, consistent with the selective default of Greece in early 2012, is that the market prices not on current but future fundamentals, expecting SWEAP fiscal space to deteriorate markedly and posing a high risk of debt restructuring. Adjustment challenges in the Eurozone may be perceived as economically and politically more difficult for SWEAP than the matched group of middle-income countries because of exchange rate and monetary constraints.

What is the risk of European sovereign debt default

We examine the discretionary use of loan loss provisions during the recent financial crisis, when Euro Area banks experienced not only a negative effect on the quality of their loans and a reduction in their profitability, but were also subject to a new form of stricter supervision, namely the EBA 2010 and 2011 stress test exercises. Overall, we find support for the only income smoothing hypothesis and we do not observe any difference in listed banks’ behavior when compared to unlisted banks. Banks subject to EBA stress tests had higher incentives to smooth income only for the 2011 EBA exercise, when a larger and more detailed set of information was released. This may suggest an unwilled side effect that accounting setters and banking regulators and supervisors should account for.

Financial crisis and international supervision: new evidence on the discretionary use of loan loss provisions at Euro Area commercial banks

This Article uses a rational choice analysis to simplify the increasingly complex area of international financial regulation. It proceeds by identifying four “interdependence problems” relating to harmonization of financial standards, capital requirements, bank resolution procedures, and an international lender of last resort — in which the globalization of finance creates potential benefits from regulatory cooperation between countries. It finds that interdependence problems that relate to the efficiency gains made available by cross-border financial integration are more amenable to international regulation than are efforts to reduce losses from financial instability, which will likely continue to be ineffective despite active reforms in response to the global financial crisis.A policy implication is that ambitious proposals for a legal body to centrally administer international financial regulation are unlikely to succeed, because they misstate the underlying dynamics of the interdependence problems that are specific to international finance. Instead, this Article argues that certain incremental reforms, such as international harmonization of bank resolution plans and provision of a regional lenders of last resort, provide a more promising avenue for reform.This Article constitutes a reframing of the literature on international financial regulation, because it seeks to show that a state-centered rational choice approach can provide greater clarity and explanatory power than competing scholarship that commonly incorporates more complicated variables. In particular, the Article argues that the influential literatures on “transgovernmental networks” of regulators and the international “soft law” that they create overstate both the extent and efficacy of these mechanisms for international cooperation on finance and international law generally.

Reframing International Financial Regulation after the Global Financial Crisis: Rational States and Interdependence, Not Regulatory Networks and Soft Law

This Article considers the application of “new governance” theory and scholarship to financial regulatory reform by examining the recent trend of incorporating proprietary internal risk models into capital adequacy regulatory regimes. I contend that theoretical scrutiny of the methodologies and tools by which financial institutions are regulated - especially the modes of interaction between financial firms, their regulators, and other nonstate stakeholders - is relatively under-emphasized in financial regulation legal scholarship. New governance scholarship focuses on these modes of interaction and tools of governance as primary units of inquiry, and offers important insights into the causes and potential remedies of regulatory dysfunction, as well as the dangers associated with increased involvement of regulatees and other nonstate actors in regulatory processes. This Article finds that the bank regulators adopted this “internal models approach” to capital adequacy in order to bridge information deficits that had grown between regulators and the increasingly complex financial institutions they regulated. Banks developed a new financial “code” using advances in computer technology and theoretical finance, which accelerated the complexity paradigm of post-Bretton Woods finance. Regulators were overwhelmed and sought to use the new financial code to better comprehend the banks’ operations. Despite its manifold advantages as a new governance tool in a highly complex and dynamic regulated field, the internal models approach falls into traps familiar to new governance reforms that render it susceptible to literal and softer forms of agency capture, and which compromise its democratic legitimacy and effectiveness.

New Governance, Financial Regulation, and Challenges to Legitimacy: The Example of the Internal Models Approach to Capital Adequacy Regulation

Was a deterioration in ‘connectedness’ a leading indicator of the European sovereign debt crisis?

The global financial crisis, the EMU sovereign debt crisis and international financial regulation: lessons from a systematic literature review

We study yield spreads between government bonds in the European Monetary Union. This segment of the global fixed income market is of particular importance for insurance companies in Europe. Our empirical research strategy is inspired by Gunay (2020) who has analyzed the relationship between credit and liquidity risk in the United States using Granger causality tests. More specifically, we employ the procedure developed by Toda and Yamamoto (1995) to test for Granger causality among yield spreads in five different member countries of the European Monetary Union (namely Austria, Belgium, France, Italy and Ireland) relative to Germany. We examine interest rate data from bonds with three different maturities (5, 10 and 30 years). Given the importance of long-term bonds as asset class for European life insurers and pension funds, the empirical results from the often ignored market for government bonds with a maturity of 30 years should be of interest. With regard to long-term sovereign debt, there is no evidence for Granger causality among the time series examined here. Consequently, the risk premia required by investors to hold government bonds of one specific member country of the EMU do not help to forecast the risk premia that have to be paid by other countries. Given the structure of their liabilities, this empirical finding should be of high relevance for portfolio and risk managers in the European life insurance industry and in pension funds. With regard to the yield spreads to be observed in the market for 10-year government bonds, there seems to be no clear picture. Focusing on fixed income securities with a maturity of 5 years, there is one very interesting empirical finding. The test results reported here seem to imply that there is unidirectional Granger causality running from the yield spreads in all other four countries to Austria. Given that Austria is a comparably small country which is assumed to be in a fiscally stable position, this result could be interpreted as evidence for credit risk premia as being helpful to forecast liquidity risk premia in the market for medium-term government bonds issued by member states of the European Monetary Union.

/pdf/risk-premia-and-the-european-government-bond-market-new-22hzt9qjnh.pdf

Risk premia and the European government bond market: new empirical evidence and some thoughts from the perspective of the life insurance industry

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The global financial crisis, the EMU sovereign debt crisis and international financial regulation: lessons from a systematic literature review

Risk premia and the European government bond market: new empirical evidence and some thoughts from the perspective of the life insurance industry