Financial Sector Linkages and the Dynamics of Bank and Sovereign Credit Spreads

Abstract

We show that cross-border financial linkages are priced in CDS markets. We construct a measure of the foreign exposure risk of a country's banking system based on the composition of its foreign exposures. Our measure helps explain CDS premia of banks. Implicit and explicit guarantees extended to a country's banking system in turn affect the CDS premia of the sovereign. As a consequence, foreign exposures of banks impact the dynamics of sovereign CDS spreads. Another measure including both foreign and domestic assets of the banks is highly signicant in explaining bank CDS spreads even before the onset of the crisis.

Keywords: Credit risk, banks, sovereign risk

JEL Classification: G01, G15, G21