Systemic Risk, Sovereign Yields and Bank Exposures in the Euro Crisis

49 Pages Posted: 31 May 2014

See all articles by Niccolò Battistini

Niccolò Battistini

Rutgers, The State University of New Jersey - Rutgers University, Newark

Marco Pagano

University of Naples Federico II - Department of Economics and Statistics; Centre for Studies in Economics and Finance (CSEF); Einaudi Institute for Economics and Finance (EIEF); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Saverio Simonelli

University of Naples Federico II - Department of Economics and Statistics; Centre for Studies in Economics and Finance (CSEF)

Date Written: April 2014

Abstract

Since 2008, eurozone sovereign yields have diverged sharply, and so have the corresponding credit default swap (CDS) premia. At the same time, banks' sovereign debt portfolios have featured an increasing home bias. In this paper, we investigate the relationship between these two facts, and its rationale. First, we inquire to what extent the dynamics of sovereign yield differentials relative to the swap rate and CDS premia reflect changes in perceived sovereign solvency risk or rather different responses to systemic risk due to the possible collapse of the euro. We do so by decomposing yield differentials and CDS spreads in a country‐specific and a common risk component via a dynamic factor model. We then investigate how the home bias of banks' sovereign portfolios responds to yield differentials and to their two components, by estimating a vector error‐correction model on 2007–13 monthly data. We find that in most countries of the eurozone, and especially in its periphery, banks' sovereign exposures respond positively to increases in yields. When bank exposures are related to the country and common risk components of yields, it turns out that (1) in the periphery, banks increase their domestic exposure in response to increases in country risk, while in core countries they do not; (2) in most eurozone countries banks respond to an increase in the common risk factor by raising their domestic exposures. Finding (1) suggests distorted incentives in periphery banks' response to changes in their own sovereign's risk. Finding (2) indicates that, when systemic risk increases, all banks tend to increase the home bias of their portfolios, making the eurozone sovereign market more segmented.

Suggested Citation

Battistini, Niccolò and Pagano, Marco and Simonelli, Saverio, Systemic Risk, Sovereign Yields and Bank Exposures in the Euro Crisis (April 2014). Economic Policy, Vol. 29, Issue 78, pp. 203-251, 2014. Available at SSRN: https://ssrn.com/abstract=2443992 or http://dx.doi.org/10.1111/1468-0327.12029

Niccolò Battistini (Contact Author)

Rutgers, The State University of New Jersey - Rutgers University, Newark

180 University Avenue
Newark, NJ 07102
United States

Marco Pagano

University of Naples Federico II - Department of Economics and Statistics ( email )

Via Cintia - Monte S. Angelo
Napoli, 80126
Italy
+39 081 675306 (Phone)
+39 081 7663540 (Fax)

Centre for Studies in Economics and Finance (CSEF) ( email )

Via Cintia
Complesso Monte S. Angelo
Naples, Naples 80126
Italy

Einaudi Institute for Economics and Finance (EIEF)

Via Sallustiana, 62
Rome, 00187
Italy

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

HOME PAGE: http:/www.ecgi.org

Saverio Simonelli

University of Naples Federico II - Department of Economics and Statistics ( email )

Via Cinthia - Monte S. Angelo
Napoli, Napoli 80126
Italy
0039 081 675366 (Phone)

HOME PAGE: http://www.csef.it/Simonelli

Centre for Studies in Economics and Finance (CSEF) ( email )

Via Cintia - Monte S. Angelo
Napoli, 80126
Italy

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