An anatomy of credit risk transfer between sovereign and financials in the Eurozone crisis

• We use daily credit default swap (CDS) spreads to capture default risk, and analyze the risk transfer between sovereign and domestic financial institutions in each country from November 2007 to October 2012.
• Before the first Greek bailout by the EFSF, the sovereign and financial sectors exhibit a two-way feedback effect for both the short and the long runs.
• Crucially, we find that after the first Greek bailout, shocks in the financial sector either exert significantly negative impacts or lose influences on the sovereign sector.
• In contrast, all the later bailouts by the EFSF (the second Greek bailout, Irish and Portugal bailouts) do not show this pattern change in the two-way risk transfer relationship.
• Our evidence supports the initiative of large-scale bailouts by the EFSF: the first Greek bailout has been a success in breaking the bank-to-sovereign risk transfer, and in ending the two-way feedback loop.

In this paper we assess the effectiveness of large scale bailouts aiming at preventing a financial crisis from further propagating into a systemic risk. We examine the structural changes in the relationship between the sovereign and financial institutions’ credit default swap spreads during the European sovereign debt crisis. Before the first Greek bailout by the European Financial Stability Facility (EFSF), the sovereign and financial sectors exhibit a two-way feedback effect for both the short and the long runs. Crucially, we find that after the first Greek bailout, shocks in the financial sector either exert significantly negative impacts or lose influences on the sovereign sector. In contrast, all the later bailouts by the EFSF (the second Greek bailout, Irish and Portugal bailouts) do not show this pattern change in the two-way risk transfer relationship.