Bank-sovereign contagion in the Eurozone: A panel VAR Approach

Abstract

During the recent global financial and Euro-area sovereign debt crises we witnessed a dramatic increase in the correlation between sovereign and bank default risk prices. In this paper we try to separate the portion of the correlation that is attributed to developments in common risk factors, which capture changes in the degree of risk aversion and the perceived amount of risk among international investors, from the impact of domestic or idiosyncratic risk factors. We employ a panel VAR model where all variables are treated as endogenous and the common risk factors are represented by widely used default and liquidity indexes. In this framework the residuals from the panel VAR model are associated with the effect that domestic/idiosyncratic factors have on sovereign and bank CDS prices. The main result we derive is that the European banking sector reacted homogeneously during the 2007:1–2009:12 period but after 2010, Euro-area Periphery countries became more “idiosyncratic”. Moreover, calculated directional volatility spillovers indicate that Eurozone periphery countries were net receivers and not net contributors to the financial instability caused by the subprime and the Eurozone sovereign debt crises.