Credit risk spillover between financials and sovereigns in the euro area, 2007–15

ABSTRACT This paper presents time-varying contagion indexes of credit risk spillover and feedback;between sixty-four financials and sovereigns in the euro area, where spillover;is identified based on bilateral Granger causality regressions. Over-identification of;contagion between financials' true credit risk and sovereign credit risk is avoided;(1) by controlling for common factors and (2) by relying on fair-value credit default;swap spreads as the credit risk measure for financials. The results show that, in particular,;the run-up to the financial crisis and the more intense phases of the crisis were;associated with credit risk contagion and feedback. The institutions identified as most;central to the network during those episodes are known to have played important roles;during the crisis. Further, the tense periods were short-lived, and sovereign-to-bank;spillover was found to normalize when policymakers took measures to stem the crisis.;Finally, a proxy for the value of implicit government guarantees to the financial sector;was still positive toward the end of the sample, suggesting the financial-sovereign;nexus had not yet been removed by new bank resolution mechanisms and regulatory;changes.