Sovereign Risk: Characteristics, History and a Review of Recent Research

Christian Friedrich Carl Buschmann

Prior to the global financial crisis, sovereign risk had become a tactical issue rather than a strategic one in the asset allocation process of financial institutions. One reason was that, since the turn of the millennium, banks’ practise of holding sovereign bonds has fallen into some disuse in favour of holding higher yielding corporate and bank bonds.¹¹See Buschmann and Heidorn (2014), p 1. This practice has somehow come to seem odd since sovereign debt has, according to the Basel II rules, still a risk weighting of 0%. The reason why holding higher risk-weighted assets was favoured was the simple fact that banks had more capital available. Another reason is that global conditions were benign. Except for Japan, debt levels and deficits of advanced economies were the lowest since the collapse of Bretton Woods in the early 1970s. Likewise, the debt levels of emerging markets have shrunk to generational low levels since the turn of the millennium, while the spreads of sovereign bonds towards their respective low-risk benchmarks (eg, US Treasuries or German Bunds) have only moved in one direction: downwards.²²See Frieda (2014), p 287.

A final, more historical, explanation has to