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The Vulnerability of Banks to Government default risk in the EMU

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  • Ivo J. M. Arnold
  • Jan J.G. Lemmen

Abstract

CThis paper examines the vulnerability of banks in EMU countries to shocks to default risk premiums on public debt. This vulnerability depends on (1) the total amount of public debt in bank portfolios, (2) the extent to which the default risk of public debt of EMU member states is diversifiable, and (3) the degree of actual geographical diversification of public debt holdings by banks. We simulate the effect of country-specific default shocks on the market value of public debt held by banks. The simulations are based on data of public debt positions at the aggregate banking sector level and take into account the historical covariance structure of default risk premiums in the EMU. We compare two scenarios. First, we calculate the domestic public debt. Next, we calculate this effect if banks diversify their investments in public debt across EMU governments. We find that the standard deviation of the equity-to-assets ratio declines considerably if banks diversify their public debt holdings and conclude that the risks of bank failures caused by default on public debt can be reduced through proper geographical diversification. We close with some implications for prudential regulation.

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File URL: http://www.lse.ac.uk/fmg/documents/specialPapers/1990s/sp115.pdf
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Bibliographic Info

Paper provided by Financial Markets Group in its series FMG Special Papers with number sp115.

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Date of creation: Jul 1999
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Handle: RePEc:fmg:fmgsps:sp115

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Web page: http://www.lse.ac.uk/fmg/

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Cited by:
  1. Ullrich, Katrin, 2006. "Market discipline and the use of government bonds as collateral in the EMU," ZEW Discussion Papers 06-46, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
  2. Georges Hübner & Robert Joliet, 2013. "Government Debt Denomination Policies Before and After the EMU Advent," Open Economies Review, Springer, vol. 24(2), pages 283-309, April.
  3. Buti, Marco & Eijffinger, Sylvester C W & Franco, Daniele, 2003. "Revisiting the Stability and Growth Pact: Grand Design or Internal Adjustment?," CEPR Discussion Papers 3692, C.E.P.R. Discussion Papers.
  4. Samir Jahjah, 2001. "Financial Stability and Fiscal Crises in a Monetary Union," IMF Working Papers 01/201, International Monetary Fund.
  5. Bernoth, Kerstin & von Hagen, Jürgen & Schuknecht, Ludger, 2004. "Sovereign risk premia in the European government bond market," Working Paper Series 0369, European Central Bank.
  6. Marta Gómez-Puig, . "Monetary integration and the cost of borrowing," Working Papers on International Economics and Finance 05-05, FEDEA.
  7. Philipp Paulus, 2006. "Brüssel, Frankfurt oder Basel - Wo muss das Problem steigender Staatsschulden in der Europäischen Währungsunion gelöst werden?," Otto-Wolff-Institut Discussion Paper Series 01/2006, Otto-Wolff-Institut für Wirtschaftsordnung, Köln, Deutschland.
  8. Beetsma, Roel & Vermeylen, Koen, 2002. "The Effect of Monetary Unification on Public Debt and its Real Return," CEPR Discussion Papers 3491, C.E.P.R. Discussion Papers.
  9. Jacek Rostowski, 2004. "The Stability and Growth Pact - Essential and Unfeasible," CASE Network Studies and Analyses 0275, CASE-Center for Social and Economic Research.
  10. Bernoth, Kerstin & von Hagen, Jürgen & Schuknecht, Ludger, 2012. "Sovereign risk premiums in the European government bond market," Journal of International Money and Finance, Elsevier, vol. 31(5), pages 975-995.
  11. Arnold, Ivo J.M., 2012. "Sovereign debt exposures and banking risks in the current EU financial crisis," Journal of Policy Modeling, Elsevier, vol. 34(6), pages 906-920.

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