Sovereign and bank Interdependencies-Evidence from the CDS market

This paper investigates the bidirectional relationship between banking and sovereign debt crises. An extended model of Bolton and Jeanne (2011) with financial intermediaries and a government sector shows that sovereign default may induce a banking crisis as banks hold a large amount of government bonds. Nevertheless, a significant amount of outright bailouts or explicit bank guarantees may constrain the short-term liquidity of the government sector and trigger a sovereign debt crisis. Empirical analyses using the credit default swap (CDS) spreads of 11 European countries and 26 commercial banks from 2006 to 2012 support the theoretical findings. First, there was minimal comovement between bank and sovereign CDS spreads at the country level before the financial crisis. The correlation has increased significantly after the outbreak of the subprime crisis but notably dropped until the Greek debt crisis. Secondly, the same set of global risk factors could explain variations in both bank and sovereign CDS spreads after 2007 with higher sensitivity to the financial sector. Lastly, the study of price dynamics reveals that bank CDS spreads assumed the leading role prior to the Lehman Brothers bankruptcy but was gradually replaced by sovereign CDS spreads during the course of the Eurozone debt crisis. This suggests that investors have interpreted the sovereign credit risk as the main source of bank risk and traded sovereign CDS contracts to hedge financial risk. Bank guarantees and bailout programs prompted deteriorating fiscal conditions that ultimately led to a reverse spillover effect from the sovereign to the financial sector.