The eurozone crisis: how banks and sovereigns came to be joined at the hip

Abstract

The eurozone sovereign and banking crisis evolved in three phases. Following the onset of the subprime tremors in July 2007, the risk premia (spreads) on bonds issued by eurozone sovereigns rose from historically low levels; but they rose largely in tandem across the eurozone membership along with global banking stresses. The rescue of the US investment bank, Bear Stearns, in March 2008, oddly enough, marked the start of a distinctively European banking crisis accompanied by increased differentiation of countries within the eurozone. With the greater expectation of public support for distressed banks, the spreads that a sovereign paid tended to rise following evidence of stress in its domestic financial sector. This was especially so in countries with lower growth prospects and higher debt burdens. But there was as yet no feedback from banks to sovereigns. Finally, as the limits of fiscal support for domestic banks became clearer, and coinciding with the nationalization of Anglo Irish in January 2009 but gathering steam with evidence of the Greek sovereign’s distress in May 2010, sovereign weaknesses also came to be quickly transmitted to a more pessimistic assessment of the financial sector’s prospects, creating the potential of mutual destabilization. — Ashoka Mody and Damiano Sandri