The quest for banking stability in the Euro area: the role of government interventions

Renatas Kizys, Nikos Paltalidis, Konstantinos Vergos

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Abstract

We build upon a Markov-Switching Bayesian Vector Autoregression (MSBVAR) model to study how the credit default swaps market in the euro area becomes an important chain in the propagation of shocks through the entire financial system. The study sheds light on the regime-dependent interconnectedness between the risk of investing in banking and public sector bonds and provides novel evidence that a rise in sovereign debt, due to the countercyclical fiscal policy measures, is perceived by stock market investors as a burden on growth prospects. We also document that government interventions in the banking sector deteriorate the credit risk of sovereign debt. Higher risk premium required by investors for holding riskier government bonds depresses the sovereign debt market, it impairs banks’ balance sheets, and it depresses the collateral value of loans leading to bank retrenchment. The ensuing two-way banking-fiscal feedback loop indicates that government interventions do not necessarily stabilize the banking sector.
Original languageEnglish
Article number0
Pages (from-to)111-133
Number of pages23
JournalJournal of International Financial Markets, Institutions and Money
Volume40
Early online date25 Sep 2015
DOIs
Publication statusPublished - 1 Jan 2016

Keywords

  • Banking Stability
  • Credit Default Swaps
  • Government Interventions
  • Markov Switching Bayesian Vector Autoregression
  • Sovereign Debt
  • Stock Market

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