How Much of Bank Credit Risk Is Sovereign Risk? Evidence from Europe

Abstract

We examine European banks' exposures to systematic and country-specific sovereign risk. We organize our investigation around a multifactor affine credit risk model estimated on CDS data of different maturities. During the 2008-2015 period, about one third of banks' credit risk is sovereign. However, banks strongly differ both in the magnitude and type of their sovereign exposures. Measures of indirect exposures, such as bank size and ROE, capture these cross-sectional differences better than measures of direct exposures. Furthermore, the properties of the distress risk premiums turn out to be important to understand the effect of sovereign risk on bank funding costs.

Keywords: Sovereign and bank credit risk; Credit default swaps; Distress risk premia; Bayesian estimation

JEL Classification: F34; G12; G15