Financial sector linkages and the dynamics of bank and sovereign credit spreads

- We use BIS banking statistics to measure foreign exposures of large banks.
- Bank CDS spreads are strongly influenced by bank foreign asset holdings.
- Sovereign CDS spreads are influenced by foreign asset holdings of domestic banks.
- Risk of foreign assets is exogenous to the sovereign/bank feedback loop.
- We measure the effect of implicit and explicit guarantees of banks on sovereign CDS premiums.

We show that CDS premiums of sovereigns are significantly affected by the foreign exposures of their domestic banks. Our analysis uses a simple risk-weighted exposure measure which aggregates detailed data on the composition and risk of banks' foreign exposures. A 1 basis point change in our risk weighted exposure measure corresponds to an average change of approximately 0.4 bp in sovereign CDS spreads. Extensive robustness checks confirm that the explanatory power of our measure is not due to common factors in CDS premiums. We also measure the size and riskiness of the sovereign's implicit and explicit guarantees extended to its domestic banking system.