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Bank and Sovereign Risk Feedback Loops

Working papers
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Download PDF: Working Paper 1

This paper studies the link between sovereign risks and the fragility of the banking sector pointing to the challenges of bank rescue operations for the state. 

Author: Aitor Erce | Senior Researcher at the European Stability Mechanism


Measures of sovereign and bank risk show occasional bouts of increased correlation, setting the stage for vicious and virtuous feedback loops. This paper models the macroeconomic phenomena underlying such bouts using CDS data for 10 euro area countries. The results show that sovereign risk feeds back into bank risk more strongly than vice versa. Countries with sovereigns that are more indebted or where banks have a larger exposure to their own sovereign, suffer larger feedback loop effects from sovereign risk into bank risk. In the opposite direction, in countries where banks fund their activities with more foreign credit and support larger levels of non-performing loans, the feedback from bank risk into sovereign risk is stronger. According to model estimates, financial rescue operations can increase feedback effects from bank risk into sovereign risk. These results can be useful for the official sector when deciding on the form of financial rescues.

Disclaimer: This Working Paper should not be reported as representing the views of the ESM. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the ESM or ESM policy. No responsibility or liability is accepted by the ESM in relation to the accuracy or completeness of the information, including any data sets, presented in this Working Paper.

JEL codes: E58, G21, G28, H63

Source: European Stability Mechanism | Working Paper Series | Volume 2016 | No 14 | May 2016 | 34 Pages

Copyright © European Stability Mechanism, 2016 | All rights reserved. Any reproduction, publication and reprint in the form of a different publication, whether printed or produced electronically, in whole or in part, is permitted only with the explicit written authorisation of the European Stability Mechanism.