Spreads and bank ratings in the Euro area sovereign debt crises

Since the inception of the Euro in 1999 there have been unprecedented movements in sovereign spreads. This has been particularly true since the beginning of the financial crises in 2008. This chapter summarizes the work in a series of papers which have examined the determinants of spreads between the 10-year benchmark government bond and the German 10-year sovereign for the main crises countries within the euro area; namely Greece, Italy, Spain, Portugal and Ireland. These studies have had a range of objectives. First, we sought to directly estimate the impact of the fundamentals. Second, we sought to determine the extent to which credit ratings assigned by the credit agencies were reflected in risk premia, given that credit ratings typically are constructed to reflect the present and prospective fundamentals of an economy. Third, we have explored the possibility of ‘Doom Loops’ between sovereign spreads and bank equity prices that is the idea that the two feed off each other in an irrational way. Finally, we argue that the market has been particularly harsh in its treatment of Greece during this episode. In this chapter we summarize this work and show how the separate pieces of work present a comprehensive picture of a serious overreaction on the part of markets and ratings agencies.