Transmission of financial stress in Europe: The pivotal role of Italy and Spain, but not Greece

This paper proposes a stochastic volatility model to measure sovereign financial distress. It examines how key European sovereign CDS affect each other, and particularly Germany, Spain and Italy as the core EU countries, after controlling for common and systematic risks. It is found that extreme bad news led to persistent and nearly permanent effects on stochastic volatility and, consequently, has an impact on sovereign CDS spreads. The stability of Germany is a close proxy for the resilience of the euro area as markets use Germany's sovereign CDS as a hedge for systemic risk. Although most of the CDS changes for Germany during 2009-16 were due to idiosyncratic factors, market developments in Italy and Spain contributed significantly, probably due to their relative size and importance in the region. Changes in Greece's sovereign CDS had no significant effect on core's European sovereign CDS despite initial widespread concerns about such linkages. Spain and Italy show a notable co-dependence in explaining each other's volatility, supporting their relative importance.1