The Changing International Network of Sovereign Debt and Financial Institutions
52 Pages Posted: 30 Aug 2016
Date Written: August 30, 2016
We develop a theoretical and empirical framework to model the international connections between financial institutions and sovereign debt markets. By allowing for both good and poor returns on the investments of financial institutions in real economy firms and the potential for haircuts in sovereign debt-markets we show how shock transmission and the default probabilities of these entities are affected through a network of these institutions. To model the financial network empirically, directional edges are established via Granger causality tests between CDS spreads, while the weights of the edges are obtained from variance decompositions. The empirical framework nests both tests of contagion and changes in the structure of the network itself. The network is found to be "robust but fragile" meaning that either a large enough single shock, or a number of small contemporaneous shocks can result in the propagation of crises. Between 2003 and 2013 for a global model of 67 financial institutions and 40 sovereigns we show that the completeness of the network changes substantially, reflecting changes in both the number and strengths of the links between them. The resulting changes in the probability of default for sovereigns and institutions demonstrate the fragility of the combined system when under stress from alternative sources.
Keywords: network, sovereign debt, financial institutions, systemic risk, contagion
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