UNCTAD Virtual Institute for Trade and Development
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Sovereign Asset and Liability Management: An E-Learning Training Course
I. The Accounting/Financial Balance Sheet
II. Sovereign Asset and Liability Management Framework: Approach I
III. Sovereign Asset and Liability Management Framework: Approach II
IV. Sovereign Asset and Liability Management Framework: Approach III
V. Contingent Liabilities
i. Explicit Liabilities: Guarantees
ii. Implicit Liabilities: Financial Sector Bailouts and Natural Disasters
iii. Managing and Mitigating Contingent Liabilities



Implicit Liabilities: Financial Sector Bailouts and Natural Disasters

“In terms of the overall impact, implicit liabilities are the most serious.  The fiscal bill of financial system bailouts, for example, averaged about 13 percent of GDP in some 40 crisis episodes but was as high as 55 percent (Leaven and Valencia, 2008).  Standard & Poor’s estimates that the average fiscal exposure to risk from the financial sector, during a reasonable worst case banking crisis, was about 27 percent of GDP across some 75 countries in mid-2008.  For the U.S. this exposure was estimated by Standard & Poor’s at 24.5 percent of GDP–in line with triple A rated countries–…Natural disasters and terrorist related events have also been very costly, with economic losses sometimes reaching 200 percent of GDP (e.g. Hurricane Ivan in Grenada in 2004)” (Cebotari, 2008).

(a.) Financial Sector Bailouts

Both Standard & Poor’s and Moody’s incorporate CL in their assessment of sovereign credit risk, with particular focus on implicit liabilities from public enterprises and potential financial system bailouts, which have proven the most costly.  In part because such liabilities are already taken into account in their credit risk assessment, both Standard & Poor’s and Moody’s indicated in the wake of the September 2008 government takeover of Fannie Mae and Freddie Mac, two of the U.S.’s government sponsored enterprises, that the bailout did not affect the U.S.’s triple-A sovereign credit ratings.” (Cebotari, 2008). 

As stated above, the reason financial sector bailouts pose such a risk to sovereigns is due to their size and the expectation of the public that the government will fulfill these obligations whether they are contractually obligated to do so or not.  One reason the government is willing to make such large financial outlays to support distressed financial systems is the cost of not doing anything is often perceived as being greater than the cost of intervening. Evidence indicates financial sector collapses impact the poorest members of society the most in the form of increased hardship that results from decreased economic output.  Consequently, policymakers are under tremendous political and economic pressure to stabilize financial markets when necessary. 

“Banking crises have become much more frequent since 1973 than in the preceding 25 years because of the easing and removal of the tight regulations surrounding domestic and international capital markets (Bordo et al., 2001).  A study found that these costs averaged 12.8 percent of GDP in 40 country experiences over the period 1970-2000.  The costs for the developing countries represented in the survey averaged 14.3% of GDP.  Some banking sector overhauls were even more expensive.  The fiscal cost of the crises in Argentina and Chile in the early 1980s was estimated to be 40-55 percent of GDP, and some estimates of the fiscal costs of dealing with the banking sector problems in the countries most affected by the East Asian crisis in the late 1990s are of a similar magnitude” (Wheeler, 2004).

 (b.) Natural Disasters

“Direct economic losses from natural disasters have often exceeded 10 percentage points of GDP in developing countries and amounted to a few percentage points of GDP in some advanced countries (Freeman, Keen, and Muthukumara, 2003); such losses are unevenly distributed across countries, as disasters usually revisit the same geographic zones.  The fiscal implications are clearly substantial, though estimates are available only for a limited sample” (Cebotari et al., 2008). “In some Latin American countries government exposure to extreme disasters (for infrastructure under its own responsibility) is up to 5.7 times the resources available to deal with these risks” (Cebotari, 2008).

The first step in mitigating losses caused by natural disasters is to reasonably determine the financial exposure.  This determination will be made based on historical frequency of natural disasters within a given region or nation and the costs of past natural disasters of the same type.  Just as the ability to predict banking and financial crises is problematic, determining the likelihood and costs of natural disasters is uncertain.  Developing models to predict the costs and frequency of natural disasters depends on accurate historical data which may not be available or limited.  Additionally, historical events are not necessarily predictors of future events, especially if climatic conditions and the probability of natural disasters are evolving.

The second step in mitigating losses from natural disasters is to transfer or share as much risk as possible.  “Following the devastation caused by Hurricane Ivan in the Caribbean, the Caribbean Community countries established in 2007, with assistance from the World Bank, the first regional disaster insurance facility in the world–the Caribbean Catastrophe Risk Insurance Facility (CCRIF).  This facility will provide participating governments with immediate liquidity if hit by a hurricane or earthquake and, by allowing Caribbean countries to pool their risk, it would significantly reduce their individual insurance premium….otherwise, countries have generally relied on self-insurance through the creation of contingency calamity funds.  Although the catastrophe insurance market is actively used by corporations, the Mexican government was the first to securitize natural catastrophe risk (earthquake) by issuing $160 million catastrophe bonds in 2006.  Catastrophe bonds forgive interest and principal in the event of specified catastrophes, allowing the money to be redirected towards disaster relief and with investors compensated for such provisions by higher interest rates before the disaster strikes” (Cebotari, 2008).

“Mechanisms available to fund the costs of recovery include hedging instruments and financing instruments.  Hedging [insurance] instruments are predisaster arrangements in which the government incurs a relatively small cost in return for the right to receive a much larger amount of money after a disaster occurs.  Insurance and capital market-based securities are examples of hedging instruments.  Financing instruments are arrangements whereby the government either sets aside funds prior to a disaster or taps its own funds after an event occurs.  This is often easier said than done as nations with limited financial resources do not have the ability to set sufficient funds aside to offset potential losses brought about by natural disasters. Ideally, the sovereign would be able to set the funds aside in advance so recovery could begin immediately and avoid policies that increase indebtedness and the problems associated with it” (Kreimer, 2002).












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