This paper aims to investigate the nexus between banks’ foreign assets and sovereign default risk in a panel of 15 developed economies. The empirical evidence suggests that banks’ foreign exposure is an important determinant of sovereign default probability.
Using data from the consolidated banking statistics (total foreign claims on ultimate risk basis) by the Bank of International Settlements, the author constructs a measure of bank international exposure to peer countries. This measure is then used as the target variable in a panel regression for sovereign credit default swaps. The model includes 15 European and non-European developed economies. Identification is discussed extensively in the paper.
Quantitatively, a 1% increase in banks’ cross-border claims increases sovereign default risk by about 0.19%. The relationship is weaker when banks are more capitalised. On the other hand, governments are more vulnerable to credit risk spillovers from banks’ international portfolios when having higher debt to GDP ratios.
To the best of the author’s knowledge, this is the first paper that attempts explicitly to establish an empirical connection between banks’ international assets and sovereign default risk. To the author’s opinion, this paper represents a contribution to our understanding of how sovereign credit risk spills over across countries. It also extends significantly the existing literature on the determinants of sovereign risk (that primarily focused on fundamentals, market characteristics – such as liquidity – and global factors). This paper ultimately sheds some new light on the role of intermediaries in the international transmission of credit risk, also adding to today’s discussion about the linkages between banks and sovereigns.
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