The Impact of the Eurozone Crisis on European Banks Stocks Contagion or Interdependence?

Abstract

JEL Classification: E6; F3; G2 1. Introduction The 2007-2009 crisis began by intense tensions in the financial systems of advanced economies and unraveled into a dramatic contraction in global growth. To prevent a larger collapse in economic activity, governments and central banks intervened massively in order to support aggregate demand--via automatic stabilizers and discretionary expenditures--and to bailout financial institutions. As a result, public finance experienced a marked degradation, leading to the emergence of the Eurozone sovereign debt crisis as a new phase of the global crisis. (1) According to the IMF Fiscal Monitor, the fiscal deficit in advanced countries (2) moves from 1.3% of the GDP in 2006 to 8.9% in 2009 while the public debt in percentage of the GDP climbed from 75.8 to 93.7 over the same period. The degradation in public finance has been more dramatic in the euro area, and more specifically in its peripheral countries. Thus, the average fiscal deficit in Greece, Ireland, Italy, Portugal, and Spain (GUPS-group) increased from 1.6% of the GDP in 2006 to 11.2% in 2009, while their public debt surged from 68.4% to 89.6% (with a projected peak at 130.5 percent of the GDP). Any drop in the market value of European sovereign debt has a negative impact on the balance sheets of European banks. Banks hold large amounts of government bonds to satisfy multiple purposes. First, investing in government bonds allows financial institutions to diversify their portfolio into low risk assets. The European prudential regulation has encouraged banks to hold such safe and liquid securities that may help to cushion losses on riskier assets. Second, holding government bonds is crucial for banks to access the central bank liquidity, insofar as the refinancing operations of the central bank are based on highly rated securities. Besides, interbank loans and repos rely heavily on the use of public bonds as collaterals. Therefore, when the value of sovereign bonds plummets it reduces both the market value of these assets in banks' balance sheets and banks' access to funding. These large holdings of Eurozone government bonds by European banks have led to a growing concern about possible spillovers from the sovereigns to the banks and a second round of spillovers from banks to sovereigns. Caruana and Avdjiev (2012) identify various channels of transmission from sovereign risks to the financial sector. First, they stress the impact of direct portfolio exposures. The Committee on the Global Finance System estimates that, for a sample of 21 advanced economies (3) at the end-2010, the banks' exposures to the domestic sovereign, measured as a percentage of banks' equities, have been above 30 percent in all countries except Austria, Ireland, and the United Kingdom (CGFS, 2011). On average, 85 percent of this exposure is held in the banking book. It is important to stress that the holding of government bonds is characterized by a strong home bias. Second, as sovereign bonds are used by banks as collaterals, a decrease in the quality of government debt may lead to a significant deterioration of funding conditions for financial institutions. (4). A third channel of transmission from sovereigns to banks resides in the fact that a marked increase in sovereign credit risk may trigger doubts on the ability of the governments to offer a credible guarantee to banks and / or financial supports in case of distress. In other terms a sovereign domestic debt crisis decreases the value of the explicit and implicit government guarantees that benefit banks that are considered too big or too interconnected (TBTF) to be allowed to fail. As these guarantees amount to very significant government subsidies (Schich and Lindh, 2012) their impairment may have a large negative impact on TBTF banks' balance sheets. This paper contributes to the growing literature on the European sovereign debt crisis by focusing on the impact of the successive crises on banks' equity returns over the period 2007-2013. …