The transmission mechanism of stress in the international banking system

Significant and volatile deviations from the covered interest parity (CIP) are indicators of stress in the international banking system. This paper uses a TVP-VAR model to investigate the dynamic connectedness and spillovers of such stress between the US, the UK, Japan and the Eurozone from 4 July 2006 to 9 June 2022. To do so, we use daily price data on cross-currency basis swaps (CRSs), typically used to trade and express CIP deviations for maturities of 1 year and beyond. We also incorporate a yield curve dimension by including prices representative of the short-term (1Y), medium-term (5Y) and long-term (10Y) to obtain a more nuanced picture of the role of market expectations. Our findings suggest that overall connectedness is highly event-dependent and peaks during periods of high volatility and market stress. However, the transmission mechanism across banking systems and yield curve maturities has evolved considerably over time, which has significant implications for policies attempting to mitigate future crises.