The Eurozone Financial Crisis: Role of Interdependencies between Bank and Sovereign Risk

34 Pages Posted: 1 Dec 2011  

James R. Barth

Auburn University; Milken Institute

Apanard P. Prabha

University of Illinois at Springfield; Milken Institute

Greg Yun

affiliation not provided to SSRN

Date Written: November 29, 2011

Abstract

Purpose: The purpose of this paper is to discuss and then analyze the interdependency between bank and sovereign risk before, during and after the financial crisis.

Design/methodology/approach: Our approach is based upon an examination of 44 large banks headquartered in 13 countries. Eight of these countries belong to the European Union, seven belong to the eurozone, and the remaining five belong to neither group. This provides a good comparison group of countries.

Findings: We find evidence supporting the existence of significant bank and sovereign risk linkages. There are, however, different patterns in the relationships across countries and even across banks within the same country. Also, higher correlations between bank and sovereign risk are found in countries in which the ratio of the assets of banks relative to their home country’s GDP is relatively high.

Research implications: Based upon our empirical results, allowing banks to invest in sovereign debt without requiring them to hold any capital against the “true” risk of such debt increases the likelihood of insolvency. This means that interdependencies between bank and sovereign risk are extremely important when setting regulatory capital requirements and considering whether action is needed to limit any increase in the likelihood of contagion.

Originality/value: The paper provides a new examination of the interdependencies between individual bank risk and the sovereign risk of the countries in which they are headquartered, with special emphasis on the recent global financial and eurozone crises.

Keywords: sovereign debt crisis, credit default swap spreads, capital requirements, risk-weighted assets, bailout, asset diversification

JEL Classification: G21, G28, F34

Suggested Citation

Barth, James R. and Prabha, Apanard P. and Yun, Greg, The Eurozone Financial Crisis: Role of Interdependencies between Bank and Sovereign Risk (November 29, 2011). Available at SSRN: https://ssrn.com/abstract=1966295 or http://dx.doi.org/10.2139/ssrn.1966295

James R. Barth

Auburn University ( email )

415 West Magnolia Avenue
Auburn, AL 36849
United States
334-844-2469 (Phone)
334-844-4960 (Fax)

Milken Institute ( email )

1250 Fourth Street
Santa Monica, CA 90401
United States

Apanard Penny Prabha (Contact Author)

University of Illinois at Springfield ( email )

Springfield, IL 62703
United States

Milken Institute ( email )

1250 Fourth Street
Santa Monica, CA 90401
United States

Greg Yun

affiliation not provided to SSRN ( email )

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