Caterina Rho (Graduate Institute, Geneva) speaks at the ESM

Pulled down by the state: the effect of sovereign shocks on banks' health in the European sovereign crisis

Abstract of the paper to be presented

The European crisis in the late 2000s has revealed a vicious circle between the financial health of governments and banks, reflecting banks' holdings of sovereign debt and government commitments to financial bailouts. Understanding the linkages between sovereign and banking risk is a central element of an effective macroprudential policy framework. However, identifying the direction of causality between the two is a major challenge. I tackle this problem by compiling a timeline of news between 2004 and 2013 and separating them into news that primarily affect banks, primarily affect governments, or impact both. The shocks identified by this narrative approach are used as instruments in a TSLS regression that estimates the effect of sovereign Credit Default Swaps (CDS) spreads on banking CDS spreads. The analysis relies on a panel of daily banking and sovereign CDS spreads for ten Euro Area countries between 2004 and 2013. I find that the impact is heterogeneous across space and time. In particular, shocks to sovereign CDS spreads in Periphery countries significantly increase the banking CDS spreads in these countries during the financial crisis. No such link is found for the Core countries. Finally, I show that policy decisions such as the intervention by Mario Draghi in July 2012 affect the transmission, and that the subsequent introduction of Outright Monetary Transactions by the European Central Bank broke the sovereign-bank nexus.

Caterina Rho is a PhD candidate in International Economics at the Graduate Institute, Geneva, whose research interests cover International Economics, Macroprudential Policy and Financial Markets. In particular, her work focuses on sovereign risk of default, banking risk of default and their interlinkage.
   

This is an ESM research internal seminar. If you would like to attend, please write an email to ESMresearch@esm.europa.eu