Country risk is the possibility that a country will be unable to service or repay its debts to foreign lenders in a timely manner. In banking, this risk arises on account of cross border lending and investment. The risk manifests itself either in the inability or the unwillingness of the obligor to meet its liability.
Country risk comprises of the following risks:
- Transfer risk which is the core risk under country risk, arises on account of the possibility of losses due to restrictions on external remittances. Consequently, an obligor may be able to pay in local currency, but may not be able to pay in foreign currency. This type of risk may occur when foreign exchange shortages either close or restrict a country’s cross border foreign exchange market.
- Sovereign risk is associated with lending to government of a sovereign nation or to taking government guarantees. The risk lies in the fact that sovereign entities may claim immunity from legal process or might not abide by a judgement, and it might prove impossible to secure redress through legal action. Ordinarily, it is assumed that there will be no default by a sovereign. This, however, does not mean that there is no risk involved in sovereign lending, for the risk may manifest itself in terms of rehabilitation of an indebted country in terms of financial solvency and liquidity for which there may be rescheduling of country debt or external debt.
- Non-sovereign or political risk arises when political environment or legislative process of a country leads to Government taking over the assets of the financial entity (e.g. nationalisation) and preventing discharge of its liabilities in a manner that had been agreed to. It is also referred to as risk of appropriation and expropriation. Non-sovereign risk includes, in addition to sovereign risk, private claims and direct investments like lending to corporates and project finance lending and includes risks associated with legal frameworks and economic environment.
Cross border risk arises on account of the borrower being a resident of a country other than the country where the cross border asset is booked, and includes exposures to local residents denominated in currencies other than the local currency.
- Currency risk is the possibility that exchange rate changes will alter the expected amount of principal and return of the lending or investment. At times, banks may try to cope with this specific risk on the lending side by shifting the risk associated with exchange rate fluctuations to the borrowers. The risk however does not get extinguished, but gets converted to credit risk.
- Macroeconomic and Structural Fragility Risk has come into prominence after the East Asian crises of 1990s. In these crises firms could purchase foreign exchange to service foreign debt but collapse of exchange rates and surge in interest rates due to severe government restrictions on firms owning external debt resulted in highly unfavourable exchange rates and very high interest costs on domestic borrowings for these firms. This severely impaired these firms’ ability to service foreign debt. The structural fragility risk can also include that associated with poor development of domestic bankruptcy laws and weak courts for their enforcement.
Broad Contours of Country Risk Management (CRM)
The broad contours of CRM are:
- Risk Categories.
- Country Risk Assessments.
- Fixing of country limits.
- Monitoring of country exposures.
Countries can be broadly classified into six risk categories – insignificant, low, moderate, high, very high and off-credit. IBA would be assigned the responsibility of developing a mechanism for assigning countries to the six risk categories specified above. Banks may be allowed to adopt a more conservative categorisation of the countries.
Country Risk (CR) Assessment
To begin with, banks may adopt the sovereign ratings of international credit rating agencies. However, banks should eventually put in place appropriate systems to move over to internal assessment of country risk within a prescribed period, say by 31 March 2005. Banks may adopt the ratings of any of the international credit rating agencies during the transition period. In case there is divergence in the ratings accorded to any country by the international credit rating agencies, banks may adopt the lower/ lowest of the ratings.
Banks should also evolve sound systems for measuring and monitoring country risk. The system should be able to identify the full dimensions of country risk as well as incorporating features that acknowledge the links between credit and market risk. Banks should use a variety of internal and external sources as a means to measure country risk. Banks should not rely solely on rating agencies or other external sources as their only country risk-monitoring tool. Banks should also incorporate information from the relevant country managers of their foreign branches into their country risk assessments. However, the rating accorded by a bank to any country should not be better than the rating of that country by the international rating agency.
The frequency of periodic reviews of country risk ratings should be at least once a year with a provision to review the rating of specific country, based on any major events in that country, where bank exposure is high, even before the next periodical review of the ratings is due.
Fixing of country limits
Bank Boards may set country exposure limits in relation to the bank’s regulatory capital (Tier I + Tier II) with sub-limits, if considered necessary for products, branches, maturity etc. The basis for setting the limits for the country/ category shall be left to the discretion of the banks’ Boards. The country exposure limits set by the Board should be reviewed periodically.
Exposure limit for any country should not exceed its regulatory capital, except in the case of insignificant risk category. In respect of foreign banks, the regulatory capital would be the capital held in their Indian books.
Banks may also set up regional exposure limits for country groups, at the discretion of their Boards. The Board may decide on the basis for grouping of countries and also lay down the guidelines regarding all aspects of such regional exposure limits.
Monitoring of country exposures
Banks should monitor their country exposures on a weekly basis before switching over to real-time monitoring. However, exposures to high-risk (and above) categories should be monitored on a real-time basis. Banks should switchover to real-time monitoring of country exposures (all categories) by 31st March 2004.
Boards should review the country risk exposures at every meeting. The review should include progress in establishing internal country rating systems, compliance with the regulatory and the internal limits, results of stress tests and the exit options available to the banks in respect of countries belonging to ‘high risk & above’ categories.
Management of country risk should incorporate stress testing as one method to monitor actual and potential risks. Stress testing should include an assessment of the impact of alternative outcomes to important underlying assumptions.
Country risk management processes employed by banks would require adequate internal controls that include audits or other appropriate oversight mechanisms to ensure the integrity of the information used by senior officials in overseeing compliance with policies and limits.