Country risk: ECAIs rating and measurement framework

Both academia and practitioners long shared the belief that default on the part of a sovereign entity was an extremely rare event. A similarly strong opinion was also that countries could not go bankrupt and, therefore, government bonds could be considered a good proxy of risk-free rates, notwithstanding the more or less recent cases of default and debt restructuring that have occurred in emerging countries. Consequently, sovereign risk assessment models were mainly oriented towards the analysis of interest rate or liquidity risk, rather than default risk. Within the approaches used to measure the possible default of a sovereign issuer, a fundamental role is played by rating agencies, which issue “Sovereign Credit Ratings” consisting of an assessment of a State’s future capability and willingness to fulfil its obligations towards its creditors. Both academics and practitioners agree that country risk is multidimensional, and the traditional measures and sovereign ratings from specialised agencies are unable to capture the specific risks of the different countries. This is especially true after the international financial crisis, which has triggered a negative spiral between sovereign risk and the credit risk of banking intermediaries, exhibiting the different transmission channels through which sovereign risk affects bank funding. Rises in sovereign risk adversely affect banks’ funding costs through several channels, due to the pervasive role of government debt in the financial system. Three major international agencies – Moody’s Investor Service, Fitch Investor Service and Standard & Poor’s – consider and assess these event risks differently in order to determine their sovereign credit rating. Starting from summer 2011, tensions in sovereign credit rating were quickly transmitted to the banking systems. In fact, sovereign downgrades have direct negative repercussions on the cost of banks’ debt and equity funding, because this is a channel through which sovereign risk adversely affects banks’ funding costs. In particular, sovereign ratings generally represent a ceiling for the ratings of domestic banks. This complex of factors has brought into the limelight, within the financial system, the so-called country risk, and has shown that the determinants of this risk have become more complex (sovereign debt structure and composition, the EMU countries sharing the euro currency and monetary policy, the ratings from the ECAIs – the External Credit Agency Institutions, etc.), intensified, and strongly interrelated as a consequence of the international financial crisis. From this perspective, the present study aims at: A. Outlining a frame for the definition of country risk and its determinants; B. Carefully examining the qualitative and quantitative information included in the different sovereign rating methodologies employed by the major ECAIs; C. Analysing the country risk measurement frameworks existing in practice and/or literature, and applying, some of them, to the Germany, Spain, Italy, France, and Greece.