The eurozone financial crisis: role of interdependencies between bank and sovereign risk

The purpose of this paper is to discuss and then analyze the interdependency between bank and sovereign risk before, during and after the financial crisis.

The authors' approach is based upon an examination of 44 large banks headquartered in 13 countries; eight of these countries belong to the European Union, seven belong to the eurozone, and the remaining five belong to neither group. This provides a good comparison group of countries.

Evidence is found supporting the existence of significant bank and sovereign risk linkages. There are, however, different patterns in the relationships across countries and even across banks within the same country. Also, higher correlations between bank and sovereign risk are found in countries in which the ratio of the assets of banks relative to their home country's GDP is relatively high.

Based upon the empirical results, allowing banks to invest in sovereign debt without requiring them to hold any capital against the “true” risk of such debt increases the likelihood of insolvency. This means that interdependencies between bank and sovereign risk are extremely important when setting regulatory capital requirements and considering whether action is needed to limit any increase in the likelihood of contagion.

The paper provides a new examination of the interdependencies between individual bank risk and the sovereign risk of the countries in which they are headquartered, with special emphasis on the recent global financial and eurozone crises.