Discussion of 

 

 Systemic Sovereign Credit Risk:

 Lessons from the U.S. and Europe 

 (Ang and Longstaff)

Viral V Acharya

NYU Stern
Overview

 The paper conducts an interesting thought experiment

 Is the credit risk of states in the U.S. inter-connected – beyond 

the common factor exposure to the U.S. economy – as much as 

appears to be the case for Eurozone countries?

 Answer: NO.

 The U.S. states are also in difficult borrowing conditions, even if 

not as much as some of the Eurozone countries.

 What drives this ex-post and ex-ante difference?
Sustainability of “sovereign” debt

 Lack of bankruptcy code (creditor rights) in case of sovereigns

 U.S. states are sovereign borrowers since under the U.S. Constitution, they 

may repudiate their debts without borrowers being able to claim assets in a 

bankruptcy process.

 What determines the sustainability of sovereign debt?

 Eaton-Gersovitz (1981), Bulow-Rogoff (1989): Fear of exlcusion 

from debt markets

 Yet, sovereigns do re-enter debt markets fairly quickly and in 

fact not at exorbitant costs (Argentina, Iceland, ...)
Sustainability of “sovereign” debt (continued)

 Recent literature focuses on a financial-sector channel, namely 

the “collateral damage” channel

 Broner-Martin-Ventura (2010), Bolton-Jeanne (2011), Gennaioli-MartinRossi (2011), Acharya-Rajan (2011), ...

 Sovereign debt is entangled with operations of financial sector

 Integrated domestic and foreign markets for sovereign borrowing

 Liquidity requirements imposed on banks

 Sovereign bonds used as collateral in inter-bank and repo markets, 

including central bank operations

 Such entanglement makes it hard for sovereigns to walk away 

from debt ex post (“willingness to pay”); but ex post if default 

does become likely (“inability to pay”), financial crisis ensues
Implications of “collateral damage” channel

 Sovereign credit risk has the potential to spill over to the 

financial sector the more entangled the two 

 If financial sector is “common” across sovereigns, then the 

entanglement could be a source of systemic risk across 

sovereigns, over and above common factor or macro exposures

 Ang and Longstaff setting: Thinking about entanglement of debt 

of US states with the financial sector – relative to entanglement 

of debt of Eurozone sovereigns with the financial sector – may 

help understand whose credit risk is more “systemic” 
Ang-Longstaff results consistent with this view

 “Given that states have tighter fiscal, political, and economic 

linkages that is the case within the Eurozone, we would expect 

that there is greater systemic risk among U.S. sovereigns.

 We find that the opposite is true:

 Only 12% of U.S. sovereign credit risk is systemic.

 In contrast, 31% of Eurozone credit risk is systemic.

 Correlations of CDS spreads are higher in Europe.

 Results provide evidence against the hypothesis that tighter 

macroeconomic linkages lead to higher levels of systemic risk.

 ... [Our] results suggest that systemic sovereign risk has its 

roots in financial markets.”

NYU STERN GLOBAL SYSTEMIC 

RISK RANKINGS

http://vlab.stern.nyu.edu/analysis/

RISK.WORLDFIN-MR.GMES

FOR ALMOST 1200 FINANCIAL INSTITUTIONS

IN COLLABORATION WITH INSTITUTE FOR 

GLOBAL FINANCE AT UNSW IN SYDNEY AND 

UNIVERSITE DE LAUSANNE IN LAUSANNE 
SYSTEM CAPITAL SHORTFALL BY COUNTRY
SYSTEM CAPITAL SHORTFALL BY COUNTRY

(% CHANGE FROM JAN 2009)
Some brief comments on methodology

 Would a common “market” factor based approach yield the 

same results as the relatively more complex – even if a fine(!) –

Duffie-Singleton framework? What is the additional gain, if any?

 “We find that the systemic credit risk of both the U.S. and the 

Eurozone is strongly related to financial market factors”

 Stock market returns, bond market returns, funding cost of 

financial firms, market volatility, ...

 BUT, market variables are highly endogenous and reflect the very 

systemic risk that authors are attempting to identify

 Is there a problem of regressing y on y?

 Would it help to isolate “shocks”? 

 US states: housing price “corrections”, interact with debt/gsp ratios

 Eurozone countries: financial crises affecting domestic institutions
Some brief comments on presentation

 Lay out the institutional differences between US states and 

Eurozone countries in greater detail

 Fiscal union and federal tax-transfer capacity imperfect in the Eurozone 

 Regulatory capital requirements on US state debt versus Eurozone 

sovereign debt

 Common banking regulatory structure across US states versus national 

regulation in Eurozone countries (deposit insurance, govt guarantees, ...)

 Extent of entanglement of US state vs Eurozone debt with financial sector
Sovereign bond holdings of 

European financials quite large

Source: Acharya, Drechsler and Schnabl (2011)
“Home bias” in bond holdings 

of European financial sector

0 .2 .4 .6 .8 1

mean of shareHome

CY SI BE AT NL UK LU FR FI SE PT DE IE DK IT MT GR ES HU PL

Source: Acharya, Drechsler and Schnabl (2011)
Some brief comments on presentation

 Lay out the institutional differences between US states and 

Eurozone countries in greater detail

 Fiscal union and federal tax-transfer capacity imperfect in the Eurozone 

 Regulatory capital requirements on US state debt versus Eurozone 

sovereign debt

 Common banking regulatory structure across US states versus national 

regulation in Eurozone countries (deposit insurance, govt guarantees, ...)

 Extent of entanglement of US state vs Eurozone debt with financial sector

 GSEs may be an interesting counter-factual for US state

 GSE deft effectively sovereign due to implicit guarantee

 Implicit guarantee much less stronger for US state-level debt

 GSE debt heavily entangled with the US financial sector (part of 

open-market operations, special capital requirements, etc.)
Entanglement of GSE debt

Holders of GSE Debt: 4Q10

Rest of the 

world

16%

Household 

sector

1%

Government

28%

Finance 

Sector

55%

Source: Federal Reserve, Credit Sights
Introduction Model Empirics Conclusion

A Motivating Example: The Case of Ireland

0 200 400 600 800

01jan2007 01jan2008 01jan2009 01jan2010 01jan2011

date

(mean) cds (mean) countrycds

Chart similar across many countries:

1 sovereign CDS close to 0 through first-half 2008

2 post bailout announcement (9/30/2008): sovereign CDS jumps up, bank CDS drops

down

3 subsequent positive comovement

Viral Acharya, Itamar Drechsler and Philipp Schnabl A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
Introduction Model Empirics Conclusion

Did Ireland have a choice? – Iceland vs. Ireland CDS

0

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Ireland

Iceland

Viral Acharya, Itamar Drechsler and Philipp Schnabl A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
Summary

 I love the thought experiment being conducted in the paper

 The results are intuitively appealing and plausible

 Authors may be able to provide stronger evidence supporting 

the financial-sector and sovereign debt nexus in Eurozone being 

a source of systemic risk there relative to the US states

 Market variables are highly endogenous and driven by 

everything, so I would reduce inference based on these

 Highly recommend reading it!