The sovereign-bank nexus in peripheral euro area: Further evidence from contingent claims analysis

New evidence is presented on the nexus between the sovereign and banking sector risk. Applying the contingent claims methodology to the peripheral euro area countries over the 2004Q4-2013Q2 period, we build indicators of sovereign and bank risk and assess their interconnection in comparison with existing market-based indicators of bank and sovereign distress. We use three different statistical measures of interdependence based on principal components analysis, Granger causality framework and Diebold-Yilmaz’s connectedness index. The empirical results show strong interconnection and co-movement between country-level banking and sovereign risk indicators. We also find evidence of bi-directional bank-sovereign causal linkages only for Spain during the European sovereign debt crisis period. For the late crisis period, we detect weak interrelationship and more divergence across the various risk indicators. Our findings indicate that secondary and derivatives market indices are more driven by common underlying factors than are contingent claim based risk measures. Finally, our results also suggest that market participants risk appetite was the main channel of risk transmission between sovereigns and banks for the countries under study during the sample period.