Financial stress relationships among Euro area countries: an R-vine copula approach

Abstract

ABSTRACTOne of the biggest challenges of keeping Euro area financial stability is the negative co-movement between the vulnerability of public finance, the financial sector, security markets stresses as well as economic growth, especially in peripheral economies. This paper utilizes a ARMA-GARCH based R-vine copula method to explore tail dependance between the Financial Stress Indices of 11 euro area countries with an aim of understanding how financial stress are interacting with each other. We find larger economies in the Euro area tend to have closer upper tail dependence in terms of positive shocks, while smaller economies tend to have closer lower tail dependence with respect to negative shocks. The R-vine copula results underline the complex dynamics of financial stress relations existing between Euro Area economies. The estimated R-vine shows Spain, Italy, France and Belgium are the most inter-connected nodes which underlying they might be more efficient targets to treat in order to achieve a quicker stabilizing. Our results relate to the fact that Eurozone is not a unified policy making area, therefore, it needs to follow divergent policies for taming the effects of financial instability to different regions or groups of economies that are more interconnected.