Abstract
The objective of this article is to analyse how the Single Supervision Mechanism (SSM), the first pillar of the European Banking Union, affects contagion between bank and sovereign risk in the eurozone. Additionally, we test whether this contagion is transmitted from banks to sovereigns or vice versa, and how this transmission differs before and after the SSM. On the one hand, using quarterly data from 80 banks and 13 eurozone countries over the period 2009–2016 (2441 observations), we do not find solid evidence that the SSM reduces contagion from sovereign risk to banks’ stock returns. On the other hand, the analysis of credit default swap (CDS) spreads comprises quarterly data from 25 banks and 10 eurozone countries between 2009 and 2016 (771 observations). We find that the announcement of the SSM in March 2013 reduces contagion between bank and sovereign CDS spreads. Additionally, before the announcement of the SSM, an increase in sovereign risk does not alter contagion. However, after this announcement, an increase in sovereign risk leads to lower contagion. Therefore, the announcement of the SSM has an immediate effect on CDS spreads, while there is not enough evidence for banks’ stock returns.
Highlights
Since the onset of the financial crisis in 2008, there has been a greater concern about sovereign and bank risk and the interdependencies between them
The financial crisis that started in 2008 raised investor concerns about sovereign risk in several European countries, which negatively affected the financial situation of the domestic banking sector and increased bank risk
Weak capital positions and liquidity problems in the banking system during the crisis were transmitted to the soundness of public finances, thereby increasing sovereign risk
Summary
Since the onset of the financial crisis in 2008, there has been a greater concern about sovereign and bank risk and the interdependencies between them. The weak capital and liquidity positions of the banking system, following the collapse of Lehman Brothers in September 2008, forced governments to rescue systemic banks This raised national deficits to alarming levels, and the credit risk of the banking sector was transmitted to sovereigns (Alter and Schüler 2012; De Bruyckere et al 2013). Greater sovereign risk was rapidly transmitted to the financial situation of the domestic banking sector, making it more risky and restricting its access to funding (Arezki et al 2011; Correa et al 2012; Cantero-Saiz et al 2014). All of these facts heightened the interconnectedness between bank and sovereign risk, especially in peripheral countries, raising serious concerns about the stability of the global financial system
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