Bank and sovereign risk pass‐through: Evidence from the euro area

• DOI: http://doi.org/10.1111/infi.12358
• Published date: 01 March 2020
• Author: Aitor Erce
• Date: 01 March 2020

International Finance. 2020;23:64–84.wileyonlinelibrary.com/journal/infi64

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© 2019 John Wiley & Sons Ltd

DOI: 10.1111/infi.12358

ORIGINAL ARTICLE

Bank and sovereign risk pass‐through: Evidence

from the euro area

Aitor Erce

European Stability Mechanism, Circuit

de la Foire Internationale, Luxembourg,

Luxembourg

Correspondence

Aitor Erce, European Stability

Mechanism, Circuit de la Foire

Internationale 6a, Luxembourg L‐1347,

Luxembourg.

Email: erceaitor@gmail.com

Abstract

Sovereign and bank risk can feed into each other and

trigger destabilizing dynamics. In this paper, I use euro‐

area countries’credit default swap data to study what

factors and shocks underlie bouts of enhanced correla-

tion between bank and sovereign risk. Sovereign risk

pass‐through, where sovereign instability undermines

domestic banks’health, is stronger than bank risk pass‐

through, where bank instability taints the sovereign’s

fiscal outlook. When banks are more exposed to the

sovereign or the latter loses its investment‐grade status,

sovereign risk transfers to banks particularly strongly. In

the other direction, risk transmits to the sovereign from

banks more strongly if the banks are larger or if the

government is bailing them out. During bailout periods,

bank risk pass‐through is more likely if banks hold more

domestic sovereign debt, they are more externally

indebted, or the sovereign debt stock is higher.

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INTRODUCTION

With the onset of the 2008 global financial crisis, some economies faced severe bank problems

whose management contributed, in turn, to subsequent fiscal distress. In other regions, in

contrast, excessively procyclical fiscal policy led foreign investors to withdraw. Since domestic

banks had become major holders of public debt, sovereign stress contributed to the eruption of

bank crises.

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These “doom loops”between banks and their sovereigns have triggered an intense

policy debate, especially within the euro area, regarding adequate ways to limit their likelihood

(Acharya, Dreschlet, & Schnabl, 2014; Acharya & Steffen, 2015; Buch, Koetter, & Ohls, 2016).

To reduce the fiscal cost of bank crises, authorities reformed the bail‐in regime for junior bank

creditors.

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To limit the effect of fiscal stress on banks, policies to limit banks’balance sheet

exposures to their own sovereign are currently under discussion (Abad, 2018; Bank for

International Settlements, 2018).

In this paper, I build an econometric framework that relates the dynamics of sovereign and bank

risk to a number of underlying vulnerabilities and shocks. I apply the model to a monthly data set on

credit default swaps (CDSs) for nine euro‐area sovereigns and 47 euro‐area banks from 2008 to 2016

to assess explanations of pass‐through effects between sovereign and bank risks. This paper’smain

contribution is to evaluate within a single framework various vulnerabilities and shocks identified by

the literature as affecting bank and sovereign risk pass‐through.

I evaluate three mechanisms affecting sovereign risk pass‐through. In line with Mody and Sandri

(2012), I look into the role of increasing public debt. The authors argue that markets are more likely to

see sovereigns as unstable and, if their debt stocks are growing rapidly, a potential source of systemic

risk. According to Correa, Lee, Sapriza, and Suarez (2014), another important determinant of bank

and sovereign stability is the sovereign‐debt credit rating. Thus, I also examine the role of the

investment‐grade status of sovereign debt. Finally, I test one of the channels to which current

literature is devoting the most attention: the role of banks’balance‐sheet exposure to their own

sovereign (Acharya et al., 2014, Angeloni & Wolff, 2012; Bocola, 2016).

I also test whether bank risk pass‐through is stronger in countries where (a) banks are

bigger, as empirically and theoretically discussed by Abad (2018) and Gennaioli, Martin, and

Rossi (2014); (b) banks are more dependent on foreign financing, as described by Cavallo and

Izquierdo (2009) and Corsetti, Eichengreen, Hale, and Tallman (2019); or (c) banks’portfolio

quality is weaker, as predicted by Acharya et al. (2014) and Bocola (2016). In addition, as

Acharya et al. (2014), I study the role of bailouts in determining the pass‐through of bank risk to

sovereign risk and whether underlying characteristics influence the degree of pass‐through.

Finally, the framework also serves to confirm the findings of Black, Correa, Huang, and Zhou

(2016) and Pagano and Sedunov (2016) regarding the role of systemic financial stress in

understanding sovereign spreads.

I document the following stylized facts. First, countries with sizable public debt, whose

banks have greater exposure to their own sovereign or whose sovereign loses its investment‐

grade status, face stronger sovereign risk pass‐through. Second, bank risk pass‐through is

stronger when banks are larger, funded by more foreign credit, or with worse asset quality.

Third, the larger the bank bailouts, on average, the more they exacerbate bank risk pass‐

through. Fourth, this effect is stronger when banks are more exposed to their own sovereign or

are more dependent on foreign financing or the sovereign is more indebted.

The next section reviews the literature. Sections 3 presents the data and Section 4 discusses

some preliminary evidence. Section 5 describes the econometric framework linking sovereign

and bank risks. Section 6 extends the framework to study sources of risk pass‐through, and

details the main results. Section 7 focuses on bank bailouts and evaluates the conditions that

increase the likelihood that a bailout triggers stronger pass‐through of bank risk. Finally,

Section 8 concludes the paper.

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LITERATURE REVIEW: PASS‐THROUGH CHANNELS?

To frame the analysis and help clarify the choice of variables used in the empirical exercise, this

section discusses the most relevant literature. Focusing on emerging markets, Reinhart and

Rogoff (2012) show that (a) banking crises, both home‐grown and imported, often accompany

sovereign debt crises, (b) public borrowing rises sharply ahead of debt crises, and (c) the

ERCE

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