Country Risk: Measurement Approaches and ECAIs Rating

Default of a sovereign entity was usually considered an extremely rare event. Similarly, countries were not commonly supposed to go bankrupt and, therefore, government bonds are usually considered a good proxy of risk-free rates, notwithstanding the more or less recent cases of default and debt restructuring that have occurred in several emerging countries. Consequently, sovereign risk assessment models were mainly addressed to deepen interest rate or liquidity risk, rather than default risk. Among the approaches used to assess the default of sovereign issuers, a pivotal role is played by rating agencies, which issue “Sovereign Credit Ratings” on States’ future capability and willingness to fulfil its obligations. International financial crisis has triggered a negative spiral between sovereign risk and the credit risk of banking intermediaries, exhibiting the different transmission channels through which sovereign risk may affect bank funding. Starting from summer 2011, 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, intensified, and strongly interrelated as a consequence of the international financial crisis. From this perspective, the present paper 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 External Credit agencies’s (ECAIs) rating methodologies; c) analysing the country risk measurement frameworks existing in practice and/or literature, applying some of them to the Germany, Spain, Italy, France, and Greece.