Abstract
Using information in US and European bank and sovereign CDS spreads we study the systematic component of banks’ credit risk that stems from banks’ common exposure to sovereign default risk. Based on a default intensity model, we find that sovereign default risk is a significant factor of bank default risk. During the period 2008-2014, on average US banks are much less sensitive to sovereign risk than their European counterparts. Within Europe the systematic component accounts for quite different proportions of the total bank default risk across countries. We also empirically confirm the asset holdings channel of the risk contagion theory by showing that a bank’s credit risk Beta (a bank’s sensitivity to sovereign risk) estimated with our model is positively related to its holdings of sovereign debt. Our findings have policy implications with respect to financial stability.
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