A Market Perspective on the European Sovereign Debt and Banking Crisis

Abstract

Europe has been beset by an interrelated banking crisis and sovereign debt crisis. Bond spreads faced by Greece and Ireland, and to a lesser extent Portugal followed by Spain, have increased. This paper explores these issues from the perspective of financial markets, focusing mainly on the four countries in the frontline of these pressures: Greece and Portugal, on the one hand, where the problems are primarily fiscal in nature; and Ireland and Spain, on the other, where banking problems related to the property boom and bust have been the key moving part. The paper first examines the probabilities of default implicit in observable market spreads and considers these calculations against sovereign debt dynamics. It then explores the implications of the interaction between bank losses and fiscal deficits on the one hand, and the feedback that any debt haircuts anticipated by markets could have on bank solvency. The study finds that market-implied sovereign default probabilities do in fact discriminate quite clearly between countries based on five criteria that affect the probability of debt restructuring. The discussion highlights some implications for banking system balance sheets of expected losses and shows the potential impact on them of sovereign restructuring implicit in market analysis. While the paper does not make any recommendations for policy action, it does explore a range of policy options and the implications each might have for the financial markets.JEL Classification:

The Impact of Sovereign Rating News on European Banks

“…First, many authors recognise the role of domestic banks as major lenders to governments, especially during times of financial turmoil (Blundell-Wignall and Slovik, 2010;Blundell-Wignall, 2011;Adler, 2012;Acharya and Rajan, 2013;Angelini et al, 2014;Gennaioli et al, 2014).…”

“…The Committee on the Global Financial System (2011) recognises that sovereign downgrades have direct negative repercussions on the cost of bank debt and equity funding. Further, the role of domestic banks as major lenders to governments is evident, especially during times of financial turmoil (Blundell-Wignall and Slovik, 2010;Blundell-Wignall, 2011;Adler, 2012;Acharya and Rajan, 2013;Gennaioli et al, 2014). On this point, Adler (2012) theorises that high bank exposure to sovereign risk causes a fragile interdependence between fiscal and bank solvency, and that this interdependence creates conditions conducive to a self-fulfilling crisis.…”

Composite Indicator of Financial Development in a Benefit‐of‐Doubt Approach

“…In fact, the existence of a strong and complex link between financial system and economic growth is clear from theoretical and empirical points of view, although this relationship is often expressed in a non-unique way (Wachtel, 2003). 5 In particular, Europe has experienced two related crises: a banking crisis linked to the losses in capital market securities and a sovereign debt crisis worsened by recession (Blundell-Wignall and Slovik, 2010;Issing, 2011). Obviously, the crisis has mainly affected countries with a greater level of financial development, which proved to be quite fragile with some issues that should be addressed quickly (Martin and Milas, 2010;Rose and Spiegel, 2011).…”

Risk contagion in the north-western and southern European stock markets

“…First, there are no published papers that have analyzed simultaneously the north-western European financial markets (France, Germany and the United Kingdom) and the southern European financial markets (Greece, Italy, Portugal, and Spain), despite concern over the recent developments in the European sovereign debt crisis, namely the risk spillover from Greece in the European and world economies (Blundell-Wignall & Slovik, 2011). In addition, this research takes into account the United States' and the Japanese main stock markets on account of their link with European markets as a potential source of risk contagion.…”