DP7833 Banking and Sovereign Risk in the Euro Area

Author(s): Stefan Gerlach , Alexander Schulz , Guntram B. Wolff

Publication Date: May 2010

Keyword(s): banking , EMU , liquidity , sovereign bond markets

JEL(s): E43 , E44 , G12

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP7833.asp.asp

We study the determinants of euro area sovereign bond spreads since the introduction of the euro. An aggregate risk factor is a main driver of spreads, both directly and indirectly by interacting with the size and structure of national banking sectors. When aggregate risk increases, countries with large banking sectors with low equity ratios experience greater widening in yield spreads, suggesting that financial markets perceive a larger risk that governments will have to rescue banks, increasing public debt and therefore sovereign risk. Moreover, government debt levels and forecasts of future fiscal deficits are also significant determinants of sovereign spreads.