## Sovereign Risk in Macroprudential Solvency Stress Testing

_IMF Working Papers, December 6, 2019_

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## Bibliographic details
- Authors: Andreas Jobst, Hiroko Oura
- Published: December 6, 2019
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781513519968.001

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### Overview and purpose
- Explains the treatment of sovereign risk in macroprudential solvency stress testing, based on experiences in the Financial Sector Assessment Program (FSAP).
- Emphasizes assessing the system-wide impact of sovereign distress on bank solvency under tail-risk scenarios.

### Key methodological components
- Four essential steps in assessing system-wide sovereign risk:
  - Scope
  - Loss estimation
  - Shock calibration
  - Capital impact calculation
- Market-consistent valuation approach is central to assessing financial sector resilience in adverse sovereign scenarios.
- Presents a flexible, closed-form approach to calibrating valuation haircuts based on changes in expected sovereign defaults affecting bank solvency during adverse macroeconomic conditions.
- Demonstrates the effectiveness of using extreme value theory (EVT) for calibrating shocks and tail-risk assessment, with empirical examples from past FSAPs.

### Findings and contributions
- Market-consistent valuation enables consistent measurement of losses from sovereign exposures in stressed scenarios.
- Closed-form haircut calibration ties changes in expected sovereign defaults directly to solvency impacts on banks.
- EVT provides an effective framework for modeling extreme sovereign distress events relevant to macroprudential stress testing.
- Empirical FSAP examples illustrate practical application of the proposed approaches.

### Policy implications and recommended practice
- Adopt market-consistent valuation in solvency stress tests involving sovereign risk to capture tail-risk dynamics.
- Use closed-form haircut calibrations that reflect changes in expected sovereign default probabilities when estimating losses on sovereign exposures.
- Incorporate EVT-based shock calibration for tail-risk scenarios to improve robustness of macroprudential solvency assessments.
- Ensure stress-testing frameworks explicitly cover scope, loss estimation, shock calibration, and capital impact calculation for sovereign exposures.

### Subjects and keywords (as listed)
- Subjects: Banking, Bond yields, Credit default swap, Credit risk, Financial institutions, Financial regulation and supervision, Financial sector policy and analysis, Financial services, Money, Stress testing, Yield curve
- Keywords: Africa, Bond yields, CDS contract, CDS spread, Credit default swap, Credit risk, discounted cash flow pricing, Global, HtM securities, macroprudential, sovereign risk, stress testing, valuation haircut, WP, Yield curve, zero-coupon bond

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_Source: https://www.imf.org/en/publications/wp/issues/2019/12/06/sovereign-risk-in-macroprudential-solvency-stress-testing-48768_