Contagion Effects between Sovereign and Bank Credit Spreads – A Global Analysis of Interdependencies between Sovereign and Bank CDS Spreads

Abstract

The interdependencies of sovereign and banking sector credit spreads have been the subject of previous research. Since the 2007-2009 financial crisis the topic has an additional dimension as the size and structure of countries’ balance sheets have changed due to various financial sector bailouts. Moreover, the euro zone sovereign debt crisis exposed the relevance of inter-regional sovereign vs. banking sector risk as financial institutions around the globe appear to be affected by euro zone member solvency issues. In this paper, we examine the contagion effects between sovereign and bank CDS spreads on the inter- and intra-regional levels as well as on the intra-country level during four sub-periods between October 2005 and April 2011. Our results show that before the sovereign debt crisis period there are few inter-regional contagion effects between sovereign vs. bank default risk. By contrast, since the sovereign debt crisis period we observe significant dependencies between the regional sovereign CDS and the regional bank CDS in other regions, predominantly for the Asia-Pacific and European sovereign risk. Conversely, we also find that changes in certain regional bank CDS impact on the sovereign CDS in other regions since the financial crisis period. On the intra-regional level, we find that the impact of bank default risk on sovereign default risk increased substantially since the onset of the financial crisis which reflects the contingent liability of the state for the financial sector in its jurisdiction exposed during the financial crisis. The strength of this finding is highest for countries which provided substantial financial support to their banking sectors, namely America and the European countries. This finding is largely confirmed on the country level whereas interesting exceptions are observed also within groups of countries that share certain properties (such as countries affected by sovereign debt problems).