Bank and Sovereign Risk Feedback Loops

European Stability Mechanism Working Paper No. 1

32 Pages Posted: 23 May 2015

Multiple version iconThere are 2 versions of this paper

Date Written: February 1, 2015

Abstract

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.

Suggested Citation

Erce, Aitor, Bank and Sovereign Risk Feedback Loops (February 1, 2015). European Stability Mechanism Working Paper No. 1, Available at SSRN: https://ssrn.com/abstract=2608864 or http://dx.doi.org/10.2139/ssrn.2608864

Aitor Erce (Contact Author)

UPNA ( email )

Pamplona
Spain

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