Much attention has been focussed on the recent surge in sovereign bond yields in the euro area. While the spread of ten-year bond yields against Germany averaged 15 basis points between the introduction of the euro in January 1999 and August 2008, they rose sharply in the financial crisis. Here, Irish and Greek government bonds traded with particularly high premia above the German Bund. Such levels have previously been associated with emerging market debt.
In this paper we seek to understand what factors have been driving these spreads. Noting that the current financial crisis is centred on the financial sector, in particular the banking sector, we argue that bank and sovereign risk has become increasingly interconnected. In particular, after the collapse of Lehman Brothers in September 2008, many if not most governments in the euro area adopted financial sector rescue packages of unprecedented size. For instance, the Irish government issued guarantees covering liabilities of more than 200 percent of GDP.
But even before the announcement of such explicit guarantees, investors arguably believed that major banks across Europe enjoyed an implicit and free government guarantee simply because the economic consequences of the failure of a systemically important institution was seen as being potentially disastrous. Since government rescues typically lead to large increases in public debt, episodes in which investors are concerned that a banking crisis might erupt are frequently associated with increase perceptions of default risk and thus in sovereign spreads.
In the paper we focus on two key questions. First, is the size of the banking sector, as measured by total assets, a determinant of sovereign spreads? Since the potential for losses in the banking sector depends on its size, we expect a positive relationship between banking sector size and sovereign risk.