Default Risk Transfer between the Eurozone Sovereign and Financial Sectors under the Effect of EFSF

Abstract

We construct a dynamic model that examines the interdependencies between the default risk of several Eurozone members and their financial institutions during the European sovereign debt crisis. The rescue package issued by the EFSF on 9 May 2010 has significant impacts on the default risk of the Eurozone sovereign and financial sectors. The main findings of this research indicate that, in the period before the first bailout issued by the EFSF, the systemic financial crisis has a “two-way feedback” effect on both the sovereign and financial sectors; after the bailout, a shock from the sovereign default risk has stronger impacts on the financial sectors, however, the impacts of a shock from the financial sector on the sovereign default risk become negative or less significant. This suggests that the EFSF bailout relieves the financial crisis for the moment, but further increases the government debt burdens in the future.