Sovereign - bank risk interconnections during the Greek financial crisis and the role of the Italian debt

The Greek crisis has brought to light the strong nexus between the credit risks of European banks and their sovereign. We study this phenomenon in Germany, France, Italy and Spain by estimating the conditional correlations between sovereign and bank CDS bond spreads over the period 2006-2015. A trivariate time-varying regime switching correlation analysis, the STCC-GARCH, is implemented to associate the state shifts to the dynamics of the so-called “transition variable†. We start selecting as transition variable the first difference of the spread between Greek and German sovereign bond yields. We then expand the model – via a DSTCC-GARCH parameterization - and introduce a second transition variable, representing the influence of the Italian sovereign debt. There is a clear evidence of significant changes in the correlations structure due to the evolution of the Greek crisis and to the sustainability of the Italian debt, which in turns impinges on the tenability of the euro project. The role of Italy on the nexuses of France and Germany increases after 2011.