Abstract
This paper draws on network theory to investigate European banks’ sovereign debt exposures. Banks’ holdings of sovereign debt build a network of financial linkages with European countries that exhibits a long-tail distribution of node degrees. A highly connected network core of 15 banks is identified. These banks accounted for the majority of sovereign debt investments between December 2010 and December 2013 but exhibited only average and sometimes even below average capitalizations. Consequently, they constituted a potential source and transmission channel of systemic risk, especially due to their proneness to portfolio contagion. In a complementary regression analysis, the effect of counterparty risk on Credit Default Swap (CDS) spreads of 15 EU sovereigns is investigated. Among the banks exposed to the debt of a particular issuer, the biggest institutions in terms of their own asset sizes are identified and some of their balance sheet characteristics included into the regression. The analysis finds that the banks’ implied volatilities had a significant and increasing effect on CDS spreads during the recent crisis years, providing evidence of the presence of counterparty risk and its effect on EU sovereign debt pricing. Furthermore, the role of the domestic financial sectors is assessed and found to have affected the CDS spreads.
Highlights
Since the 2008 economic crisis, the global system of financial institutions has shown to be able to transmit financial shocks at a rapid speed
While governments tried to reanimate their economies through quantitative easing and other financial support initiatives, they had to deal with slumped growth and rising unemployment levels
The analysis shows that these banks’ implied volatilities have had a considerable effect on EU countries’ Credit Default Swap (CDS) spreads
Summary
Since the 2008 economic crisis, the global system of financial institutions has shown to be able to transmit financial shocks at a rapid speed. A complex and obscure web of over-the-counter transactions, a growing shadow banking system, and information asymmetries on part of regulators help to explain why a comparatively small shock event like the US subprime mortgage crisis could have such large repercussions In this context regulatory frameworks such as Basel II turned out to be inadequate, which was engraved by the tendency of capital requirements to be pro-cyclical (EEAG [1]). Building on the work of Signori and Gençay [7] who assess counterparty risk in the US supplier-customer network of public companies, the paper applies their network approach to the bank-sovereign network Those six banks that are the biggest institutions in terms of their own asset sizes among the banks exposed to the debt of particular issuer are identified. This is followed by the regression analysis in part five before the paper concludes part six
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