Systemic risk, sovereign yields and bank exposures in the euro crisis

Abstract

Since 2008, euro-area sovereign yields have diverged sharply, and so have the corresponding CDS premia. At the same time, banks' sovereign debt portfolios featured an increasing home bias. We investigate the relationship between these two facts, and its rationale. First, we inquire to what extent the dynamics of sovereign yield differentials relative to the swap rate and CDS premia reflect changes in perceived sovereign solvency risk or rather different responses to systemic risk due to the possible collapse of the euro. We do so by decomposing yield differentials and CDS spreads in a country-specific and a common risk component via a dynamic factor model. We then investigate how the home bias of banks' sovereign portfolios responds to yield differentials and to their two components, by estimating a vector error-correction model on 2008-12 monthly data. We find that in most countries of the euro area, and especially in its periphery, banks' sovereign exposures respond positively to increases in yields. When bank exposures are related to the country-risk and common-risk components of yields, it turns out that (i) in the periphery, banks increase their domestic exposure in response to increases in country risk, while in core countries they do not; (ii) in most euro area banks respond to an increase in the common risk factor by raising their domestic exposures. Finding (i) hints at distorted incentives in periphery banks' response to changes in their own sovereign's risk. Finding (ii) indicates that, when systemic risk increases, all banks tend to increase the home bias of their portfolios, making the euro-area sovereign market more segmented.

Lessons from the European financial crisis

“…As already mentioned, Battistini, Pagano and Simonelli (2014) find that the sovereign exposures of euro-area banks respond positively to increases in yields in most countries, except Belgium, France and the Netherlands. But this pattern stems from a very different response of sovereign exposures to the country risk factor in the core and in the periphery:…”

“…Battistini, Pagano and Simonelli (2014) find that, in general, they were: banks invested more in their home sovereign's debt when its yield increased. They also explore how the changes in domestic exposures responded to two components of yield differentials: a common (or systemic) component, which they interpret as reflecting mainly the risk of euro collapse (i.e., a redenomination risk premium), and a country-specific component, driven mainly by countrylevel changes in sovereign risk.…”

“…The risk of euro-area breakup and devaluation of periphery countries' future currencies vis-à-vis those of core countries determined a strong co-movement in sovereign yield differentials and CDS sovereign premia (Battistini, Pagano and Simonelli, 2014) Greece would leave the euro-area in the subsequent 12 months, followed by Portugal, and assessed at 50% the chance that the euro area would break up in the subsequent three to five years. Even ECB President Mario Draghi pointed to the effect of redenomination risk on sovereign yield differentials when he stated in a speech on 26 July 2012 that "the premia that are being charged on sovereign states borrowings … have to do more and more with convertibility, with the risk of convertibility".…”

“…The rationale for this impending policy change is reinforced by the fact that it has become clear that, when euro-area governments are fiscally distressed, they are no longer the only ultimate backstops of their domestic banks, as illustrated by the contribution of the European Stability Mechanism (ESM) to the recapitalization of Spanish banks since late 2012: it is then consistent that, ex ante, an euro-area bank supervisor should constrain the bets that euro-area banks can take on the bonds issued by their distressed sovereign. Battistini et al (2014) could also be interpreted as indicating that periphery banks increased their sovereign exposures to search for yield, especially since most of these banks were undercapitalized and could borrow cheaply from the ECB: if successful, their sovereign-debt carry trades would help them to shore up their capital ratios. Indeed, Acharya and Steffen (2013) and Buch, Koetter and Ohls (2013) provide evidence that banks that were less capitalized and more dependent on wholesale funding invested more in sovereign debt than others.…”

An update on EMU sovereign yield spread drivers in times of crisis: A panel data analysis

“…In this paper implied volatility has been used to gauge both regional and global stock market volatility. In particular, the variables VSTOXX and VIX, which measure implied volatility in Eurostoxx-50 and Standard and Poor's 500 index options and have been widely used in the literature by other authors (see, e.g., Afonso, 2012, Aizenman et al, 2013, and Battistini et al, 2013 as measures of uncertainty in the Eurozone and the global financial markets respectively. However, since implied volatility indices were not available for all countries, we opted for the monthly standard deviation of equity returns in each country to capture local stock market volatility.…”