Co-movements in EU banks’ fragility: a dynamic factor model approach

We analyse co-movements in the fragility of EU banks and verify to which extent such co-movements have increased in time, following, for example, the completion of Monetary Union and the introduction of the euro. To this end, we provide a measure of co-movements in bank risk by means of a dynamic factor model, which allows to decompose an indicator of bank fragility, the Distance-to-Default, into three main components: an EU- wide, a country-specific and a bank-level idiosyncratic component. Our results show the commonality in bank risk appears to have significantly increased since 1999, in particular if one concentrates on large banks. This has obvious consequences in terms of systemic stability, but may also have far reaching policy implications with regards to the structuring of banking supervision in Europe (i.e. it increases the scope for supervisory co-operation at EU-wide level). We also believe that co-movements in bank conditions are important for monetary policy since banks still constitute monetary policy’s most important transmission channel.