Lars Jul Overby

It can be argued that sovereign risk refers to ‘black swan’ events as characterised in Taleb (2008), rare and extreme events with retrospective (though not prospective) predictability. In addition since banking risk is intrinsically linked to sovereign risks, it can also be denoted as a ‘white elephant’ type of risk, i.e. a risk that although it has the potential to be costly, it is also difficult, if not impossible, to dispose of. While both views have some wisdom, the truth probably lies in between. Sovereign risk has for long been highlighted as an issue, but perceived as unlikely to crystallise in Europe and too difficult to address effectively, given the strong interlinkages between governments, monetary policy and banking systems. Nonetheless, the current preferential treatment of sovereign risk in the banking regulatory framework was clearly challenged during the financial crisis. The lack of risk sensitivity and incentives in the prudential framework to manage sovereign risk actively may have led to complacency prior to the EU sovereign debt crisis, as empirical evidence illustrates limited diversification and significant home-bias in the holdings of sovereign assets. Consequently, increased reliance on mark-to-market valuations of sovereign exposures, standardised disclosure and regulatory incentives to diversify sovereign risk would lead to a more robust framework that, although it may not eliminate the risk of sovereign black swan events, will mitigate the impact and hopefully make the white elephant smaller.