This study attempts to identify and trace inter-linkages between sovereign and banking risk for each country in the euro area. To this end, we use an indicator of banking sector risk in each country based on the Contingent Claim Analysis literature, and 10-year government yield spreads over Germany as a measure of sovereign risk. We apply a dynamic approach to testing for Granger causality between the two measures of risk in each country, allowing us to check for episodes of significant and abrupt increase in short-run causal linkages. The empirical results indicate that episodes of causality intensification vary considerably in both directions over time and across the different EMU countries. The directionality suggests the presence of causality intensification, mainly from banks to sovereigns in crisis periods.
Highlights1. We estimate the banking sector risk behavior in EMU over the period 2004Q4-2013Q2; 2. We compute average "Distance-to-default (DtD)" for a representative set of banks at country level;3. Average DtD is strongly correlated with market sentiments and outperform regulatory risk measures; 4. GC test reveal no systemic component and Diebold-Yilmaz index suggest low connectedness; 5. Results suggest more cautious requirement in modeling a priori dependence among bank. Abstract Comment [E1]:Author: Two different versions of Abstracts were provided and the one in the ms has been retained. Please check that is correct.Given the structural differences in banking sector and financial regulation at country level in European Economic and Monetary Union (EMU), this paper tries to estimate the banking sector risk behavior at country level. Based on contingent claim literature, it computes "Distance-to-default (DtD)" at bank level and analyses the aggregate series at country level for a representative set of banks over the period 2004-Q4 to 2013-Q2. The indices provide an intuitive, forward-looking and timely risk measure having strong correlations with national/regional market sentiment indicators. An underlying trend exists but causality tests suggest no systemic component. Cross-sectional differences in DtD suggests fragility in EMU countries 12-18 months prior to the crisis and better predictive ability than the regulatory index based on large and complex banking institutions at European level. Furthermore, we explore the reasons for this divergence using VAR estimates.JEL: G01 G13 G21 G28 IntroductionThe 2007-08 financial crisis and the subsequent European sovereign debt crisis have exacerbated the need to understand and monitor the bank risk behavior. Renewed attention is being focused at the global scale to enhance and extend risk measurement methodologies. The eurozone is no exception and the twin objective of the European Central Bank (ECB) -price and financial system stability -places a strong emphasis on Systemically Important Financial Institutions (SIFI) but relies on individual countries' central banks to supervise smaller financial institutions.This paper deviates from this current and in our view excessive focus and attention on detecting and monitoring risk at European banking level. We take a step backward and introduce a micro approach to document and monitor the buildup of banking sector risk at country level. Based on contingent claims literature, we calculate Distance-to-default (DtD) at bank level and analyze the aggregate series at country level for a representative set of banks over the period 2004-Q4 to 2013-Q2.Conceivably, if regulators pay greater attention to country-specific buildups of risk and their connectedness, they might take actions earlier to mitigate the extent and impact of future crisis.There are many reasons for this choice. First, the structure of the banking sector within EMU countries varies considerably. In the case of Germany, Finland and the Netherlands, total banking ...
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