Responding to the Eurozone Crisis - Applying the Shadow Rating Approach to Determine Economic Capital for Sovereign Exposures

Abstract: The recent European sovereign-debt crisis has made it clear that exposures towards sovereigns contain credit risk. However, according to the Basel framework's standardized approach banks are not required to hold any regulatory capital for highly rated sovereigns. In response, this thesis develops a shadow rating approach model for sovereign probability of default estimation, subsequently determining economic capital for sovereign exposures within a foundation internal ratings-based framework. Furthermore, the empirical Bayes estimator is utilized for low-default portfolio probability of default calibration. The model is tested on ve homogeneous sub-segments in addition to the entire dataset at hand. Empirical ndings suggest that the full dataset performs adequately overall. Nonetheless, model performance is superior for accurately constructed sub-segments. In addition, economic, monetary and political indicators as well as banking sector health are found to best replicate S&P's sovereign long-term issuer credit ratings.