New Directions in Financial Sector and Sovereign Risk Management

Dale Gray and Andreas A. Jobst

Volume 8, Number 1, First Quarter 2010

The global financial crisis that began in 2007 has forced a re-examination of macroeconomics, financial economics, regulation, and risk management. Traditional macroeconomics overlooks the importance of risk which makes it ill-suited to analyze risk transmission, contagion and how risks can build up and suddenly erupt in a full blown crisis. Risk management concentrates on analysis of risk at the level of the individual institution. What has been missing is comprehensive analysis of systemic financial risk and its links to sovereign risk. This essay illustrates how risk management tools and contingent claims analysis (CCA) can be applied in new ways to the financial system, to economic sectors and the national economy. CCA is a valuable tool to improve systemic financial sector and sovereign risk management. A new framework is developed to help the measurement, analysis and management of systemic risk with immediate practical application to the analysis of government risk exposures, their associated contingent liablities, and potential destabilizing feedback processes between the financial sector and the sovereign balance sheet. In this regard, a new framework called Systemic CCA is described and an illustration of its application is given. This paper concludes with proposals on several new directions in managing financial sector and sovereign risk.