A Sovereign Risk-Based Approach to Implementing Countercyclical Capital Buffer Schemes

Based on the macro-financial risk framework of Gray et al. (2006) that links the balance sheets of the financial sector and public sector together through government guarantees, we propose an indicator, sovereign distance-to-default (SDD), for implementing the countercyclical capital buffer schemes of Basel III. Using a sample of 29 European countries from 1975 to 2011, we find that SDD outperforms credit-to-GDP ratio, the primary indicator recommended by the Basel Committee for Banking Supervision. More specifically, SDD generates more reliable signals for the build-up of capital buffers three years prior to a crisis and the release of capital buffers in the same year that the crisis occurs. Our findings suggest that SDD can be used as a leading indicator for the build-up phase and an anchor for the release phase of the countercyclical capital buffer schemes.