Sovereign risk and Financial Stability. Evidence from Eurozone Countries

Abstract

We will investigate in this paper the relationship between sovereign risk and domestic banks' exposure to the government debt, using data for eurozone countries. The sovereign-bank nexus shows that there are substantial influences between the fiscal and the financial sector and that in absence of enough fiscal buffers, the rise in public borrowing will contribute to financial market imbalances, through various channels. We apply impulse-response functions in order to investigate the effect of a shock produced to sovereign risk to banks' exposure to government debt. Our results confirm that there are significant interlinkages between sustainable fiscal positions and financial markets performance, so that reducing debt levels can contribute to decreasing sovereign risk premia and improvement in financial conditions, decreasing the exposure of the banking sector to holding large shares of debt, which can result in deteriorating economic conditions.