Hazardous Tango: Sovereign-Bank Interdependencies Across Countries and Time

Abstract

Sovereign-bank feedback loops have been at the heart of the euro area crisis and many previous debt crises. We regress a market measure of interdependency – the correlation between sovereign and bank credit default swaps (CDS) – against various fundamental indicators of interlinkages and risk for 65 banks from 23 countries from Q1 2006 to Q4 2015. We find evidence that direct sovereign debt holdings of banks, implicit contingent liabilities of the government to banks and market volatility are significantly linked to higher correlations. While such CDS correlations are generally higher for banks in countries bank-based financial systems, we do not find these channels to be stronger in these countries than market-based systems. Finally, we find that bank CDS levels perform better in explaining sovereign CDS levels in periods of high volatility. Overall, these results support the notion of non-linear effects and spillovers in CDS markets.