Publication: Sovereigns and banks in the euro area: A tale of two crises
Full text at PDC
Advisors (or tutors)
Asociación Española de Economía y Finanzas Internacionales
This study attempts to identify and trace inter-linkages between sovereign and banking risk in the euro area. To this end, we use an indicator of banking risk in each country based on the Contingent Claim Analysis literature, and 10-year government yield spreads over Germany as a measure of sovereign risk. We apply a dynamic approach to testing for Granger causality between the two measures of risk in 10 euro area countries, allowing us to check for contagion in the form of a significant and abrupt increase in short-run causal linkages. The empirical results indicate that episodes of contagion vary considerably in both directions over time and within the different EMU countries. Significantly, we find that causal linkages tend to strengthen particularly at the time of major financial crises. The empirical evidence suggests the presence of contagion, mainly from banks to sovereigns.
Alter, A., & Schüler, Y. S. (2012). Credit spread interdependencies of European states and banks during the financial crisis. Journal of Banking and Finance, 36, 3444-3468. Alter, A., & Beyer, A. (2014). The dynamics of spillover effects during the European sovereign debt turmoil. Journal of Banking and Finance, 42, 134–153. Acharya, V., & Steffen, S. (2013). The “greatest” carry trade ever? Understanding Eurozone bank risks. Working Paper 19039, National Bureau of Economic Research, Cambridge, MA. Acharya, V., Drechsler, I., & Schnabl, P. (2014). A pyrrhic victory? Bank bailouts and sovereign credit risk. The Journal of Finance, forthcoming. Beirne, J., & Fratzscher, M. (2013). The pricing of sovereign risk and contagion during the European sovereign debt crisis. Journal of International Money and Finance, 34, 60-82. Bank for International Settlements (2009). 79th Annual Report, Basel. Brunnermeier, M. K., Garicano, L., Lane, P. R., Pagano, M., Reis, R., Santos, T., Van Nieuwerburgh, S., & Vayanos, D. (2011). European Safe Bonds. ESBies.www.euronomics.com. Caporin, M., Pelizzon, L., Ravazzolo, F., & Rigobon, R. (2013). Measuring sovereign contagion in Europe. Working Paper 18741, National Bureau of Economic Research, Cambridge, MA. Constâncio, V. (2012). Contagion and the European debt crisis. Financial Stability Review, 16, 109-119. Corsetti, G., Pericoli, M., & Sbracia, M. (2005). Some contagion, some interdependence: more pitfalls in tests of financial contagion. Journal of International Money and Finance, 24, 1177-1199. Cheung, Y.-W., & Chinn, M. D. (1997). Further investigation of the uncertain unit root in GNP. Journal of Business and Economic Statistics, 15, 68-73. Cochrane, J. H. (2011). Understanding policy in the great recession: Some unpleasant fiscal arithmetic. European Economic Review, 55, 2–30. De Bruyckere, V., Gerhardt, M., Schepens, G., & Vennet, R.V. (2013). Bank/sovereign risk spillovers in the European debt crisis. Journal of Banking and Finance, 37, 4793–4809. Delong, B. J., & Summers, L. H. (2012). Fiscal policy in a depressed economy. Brookings Papers on Economic Activity, Spring. Dolado, J. J., Jenkinson, T., & Sosvilla-Rivero, S. (1990). Cointegration and unit roots. Journal of Economic Surveys, 4, 149-173. Duggar, E., & Mitra, S. (2007). External linkages and contagion risk in Irish banks. Working Papers 07/44, International Monetary Fund, Washington, D.C. Edwards, S. (2000). Contagion. World Economics, 23, 873–900. Eichengreen, B., & Rose, A. (1999). Contagious currency crises: channels of conveyance. In T. Ito & A. Krueger (Eds.), Changes in Exchange Rates in Rapidly Developing Countries: Theory, Practice and Policy Issues (pp. 29–50). Chicago: University of Chicago Press. Ejsing, J., & Lemke, W. (2011). The Janus-headed salvation: Sovereign and bank credit risk Premia during 2008–2009. Economic Letters, 110, 28–31. European Central Bank (2014). The determinants of euro area sovereign bond yield spreads during the crisis. Monthly Bulletin, May, 67-83. Fontana, A., & Scheicher, M. (2010). An analysis of euro area sovereign CDS and their relation with government bonds. Working Paper 1271, European Central Bank, Frankfurt am Main. Forbes, K., & Rigobon, R. (2001). Measuring contagion: Conceptual and empirical issues. In S. Claessens & K. Forbes (Eds) International Financial Contagion (pp. 43-66). Norwell, MA: Kluwer Academic Publishers. Forbes, K. & Rigobon, R. (2002). No contagion, only interdependence: Measuring stock market comovements. Journal of Finance, 57, 2223-2261. Gómez-Puig, M. & Sosvilla-Rivero, S. (2013). Granger-causality in peripheral EMU public debt markets: A dynamic Approach. Journal of Banking and Finance, 37, 4627-4649. Gómez-Puig, M. & Sosvilla-Rivero, S. (2014). EMU sovereign debt markets crisis: Fundamentalsbased or pure contagion? Working Paper 2014/02, Institut de Recerca en Economia Aplicada, Universitat de Barcelona. Granger, C. W. J. (1969). Investigating causal relations by econometric models and crossspectral methods. Econometrica, 37, 24-36. Gray, D. & Jobst, A. (2010). Lessons from the financial crisis on modeling systemic risk and sovereign risk. In A. Berd (Ed.), Lessons from the Financial Crisis. RISK Books, London. Gray, D. & Jobst, A., (2013). Systemic contingent claims analysis: Estimating market-implied systemic risk. Working Papers 13/54, International Monetary Fund, Washington, D.C. Gray, D., Merton, R. & Bodie, Z., (2007). New framework for measuring and managing macrofinancial risk and financial stability. Working Paper 13607, National Bureau of Economic Research, Cambridge, MA. Gray, D., Jobst, A. & Malone, S., (2010). Quantifying systemic risk and reconceptualizing the role of finance for economic growth. Journal of Investment Management, 8, 90-110. Gropp, R., Vesala, J. & Vulpers, G. (2006). Equity and bond market signals as leading indicators of bank fragility. Journal of Money, Credit and Banking, 38, 399-428. Gross, M. & Kok, C. (2013). Measuring contagion potential among sovereigns and banks using a mixed-cross-section GVAR. Working Paper 1570, European Central Bank, Frankfurt am Main. Harada, K., Ito, T. & Takahashi, S. (2013). Is the distance to default a good measure in predicting bank failures? A case study of Japanese major banks. Japan and the World Economy, 27, 70–82. Hau, H., Langfield, S. & Marquez-Ibanez, D. (2012). Bank ratings: what determines their quality?. Working Paper 1484, European Central Bank, Frankfurt am Main. Hendry, D. F. & Mizon, G. E. (1999). The pervasiveness of Granger causality in Econometrics. In R. F. Engle & H. White (Eds.) Cointegration, Causality, and Forecasting. A Festsschrift in Honour of Clive W. J. Granger (pp. 102-134). Oxford: Oxford University Press. Hoover, K. D. (2001). Causality in Macroeconomics. Cambridge: Cambridge University Press. Hsiao, C. (1981). Autoregressive modelling and money-income causality detection. Journal of Monetary Economics, 7, 85–106. International Monetary Fund (2011). Addressing fiscal challenges to reduce economic risks. IMF Fiscal Monitor. September. Johansen, S. (1991). Estimation and hypothesis testing of cointegration vectors in Gaussian vector autoregressive models. Econometrica, 59, 1551-1580. Johansen, S. (1995). Likelihood-based inference in cointegrated vector autoregressive models. Oxford: Oxford University Press. Kaminsky, G. & Reinhart, C. (1999). The twin crises: the cause of banking and balance-ofpayments problems. American Economic Review, 89, 473–500. Kealhofer, S. (2003). Quantifying credit risk: Default prediction. Financial Analyst Journal, 59, 30-44. Kwiatkowski, D., Phillips, P.C.B., Schmidt, P. & Shin, P. (1992). Testing the null hypothesis of stationarity against the alternative of a unit root. Journal of Econometrics, 54, 159–178. Krugman, P. (2011). Self-defeating austerity. New York Times, July 7. Lenza, M., Pill, H. & Reichlin, L. (2010). Monetary policy in exceptional times. Economic Policy, 62, 295-339. Masson, P. (1998). Contagion, monsoonal effects, spillovers, and jumps between multiple equilibria. Working Paper 98/142, International Monetary Fund, Washington, D.C. Merton, R. C. (1974). On the pricing of corporate debt: The risk structure of interest rates. Journal of Finance, 29, 449-470. Mody, A. & Sandri, D. (2012). The Eurozone crisis: How banks and sovereigns came to be joined at the hip. Economic Policy, 27, 199–230. Oderda, G., Dacorogna, M. & Jung, T. (2003). Credit risk models: do they deliver their promises? A quantitative assessment. Review of Banking, Finance and Monetary Economics, 32, 177-195. Palladini, G. & Portes, R. (2011). Sovereign CDS and bond pricing dynamics in the euro-area. Working Paper 17586, National Bureau of Economic Research, Cambridge, MA. Petrovic, A. & Tutsch, R. (2009). National rescue measures in response to the current financial crisis. Legal Working Paper 8, European Central Bank, Frankfurt am Main. Pisany-Ferry, J., Saprir, A. & Wolff, G. B. (2013). EU-IMF assistance to euro-area countries: an early assessment. Brussels: Bruegel. Saldias, M. (2013). Systemic risk analysis using forward-looking distance-to-default series. Journal of Financial Stability, 9, 498-517. Shambaugh, J. C. (2012). The euro’s three crises. Brookings Papers on Economic Activity, 44, 157-211. Sims, C. A. (1972). Money, income, and causality. American Economic Review, 62, 540-552. Singh, M. K., Gómez-Puig, M. & Sosvilla-Rivero, S. (2014). Forward looking banking stress in EMU countries. Working Paper 2014/22. Institut de Recerca en Economia Aplicada, Universitat de Barcelona. Susan, T.; Singh, M. K. & Aggarwal, N., (2012). Do changes in distance-to-default anticipate changes in the credit rating? Working Paper 2012-010, Indira Gandhi Institute of Development Research, Mumbai. Stolz, S. M. & Wedow, M. (2010). Extraordinary measures in extraordinary times: public measures in support of the financial sector in the EU and the United States. Occasional Paper 117, European Central Bank, Frankfurt am Main. Reichlin, L. (2013). The ECB and the banks: the tale of two crises. Discussion Paper 964, Centre for Economic Policy Research, London. Reinhart, C. M. & Rogoff, K. S. (2010). Growth in a time of debt. American Economic Review, 100, 573-578. Thornton, D. L. & Batten, D. S. (1985). Lag-length selection and tests of Granger causality between money and income. Journal of Money, Credit, and banking, 27, 164-178. Toader, O. (2013). Quantifying and explaining implicit public guarantees for european banks.Working Paper 3062. University of Orléans, Orléans. Uhlig, H. (2013). Sovereign default risk and banks in a Monetary Union. Working Paper 19343, National Bureau of Economic Research, Cambridge, MA. Vassalou, M. & Yuhang, X., (2004). Default risk in equity returns. Journal of Finance, 59, 831-868. Williams, E. J. (1959). Regression analysis. Wiley: New York.