Abstract
Crises in the banking and sovereign debt sectors give rise to heightened financial fragility. Of particular concern is the development of self-fulfilling feedback loops where crisis conditions in one sector are transmitted to the other sector and back again. We use time-varying tests of Granger causality to demonstrate how empirical evidence of connectivity between the banking and sovereign sectors can be detected, and provide an application to the Greek, Irish, Italian, Portuguese and Spanish (GIIPS) countries and Germany over the period 2007 to 2016. While the results provide evidence of domestic feedback loops, the most important finding is that financial fragility is an international problem and cannot be dealt with purely on a country-by-country basis.
Highlights
Crisis conditions in the financial sector can be propagated and reinforced by a vicious feedback loop between the banking sector and the sovereign debt sector
The feedback loop relies on two stylized facts: first, banks typically have large holdings of sovereign debt on their balance sheets and, second, when governments bailout an ailing financial sector they fund this by issuing sovereign debt
The contribution made by this paper relates to econometric modelling in the sense that a recently-developed econometric method is used in a new and innovative way to address a contemporary question of immense importance, namely, the relationship between the sovereign debt and banking sectors in times of crisis
Summary
Crisis conditions in the financial sector can be propagated and reinforced by a vicious feedback loop between the banking sector and the sovereign debt sector. The empirical work reported here follows convention and focusses only on direct links This choice is dictated by the explicit focus of the paper on sub-sampling and changing causal structures, a focus which de-emphasises the existence of a constant model structure in which indirect links are able to be identified reliably. The contribution made by this paper relates to econometric modelling in the sense that a recently-developed econometric method is used in a new and innovative way to address a contemporary question of immense importance, namely, the relationship between the sovereign debt and banking sectors in times of crisis These new econometric tools are potentially relevant to many policy problems, and our contribution includes the adjustments necessary to move between econometric theory and a sophisticated practical application.
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