For decades, the regulatory treatment of sovereign debt has significantly discounted and, in many cases, ignored the possibility of default on exposures that are denominated and funded in the country’s own currency. Sovereign risk, however, is not a novel concept. Sovereign defaults, though not as frequent as those in the private sector, have occurred regularly throughout history. The recent financial crisis and subsequent distress suffered by a number of sovereigns, including some EU Member States, has further highlighted these risks. Indeed, the bond spreads and credit default swap (CDS) premia observed for a number of sovereigns suggest that the possibility of default is clearly non-negligible.
The crisis has also highlighted a close two-way link between banking and sovereign distress, with problems in the banking sector having a negative effect on the sovereign, and sovereign stress exacerbating the disruption in the banking system.
The ESRB’s Advisory Scientific Committee (ASC) has stressed the need for comprehensive reform, for instance of the risk weight of sovereign debt in prudential regulation.”
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