Abstract
We study the link of sovereign and bank credit risks in the euro area by extracting default information from the most liquid 5Y CDS spreads over the period 2010-2014. Using German CDS spread and iTraxx financials index as proxies for systemic default risk of sovereigns and banks, we estimate the systemic credit risk and idiosyncratic credit risk of each sovereign and bank. We find that after controlling for both global macroeconomic shocks and country-specific risks, idiosyncratic sovereign credit risk change can explain bank credit risk change. We also find that co-integration between sovereign and bank only exists in Belgium and Greece. Results of error correction model reveal that credit risk of Belgian bank Granger-causes sovereign credit risk due to the massive government bail-out while in Greece this is not found since the crisis is rooted in the high fiscal deficit of Greek government.
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