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Avoiding the fall into the loop: Isolating the transmission of bank-to-sovereign distress in the Euro Area

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  • Böhm, Hannes
  • Eichler, Stefan

Abstract

While the sovereign-bank loop literature has demonstrated the amplification between sovereign and bank risks in the Euro Area, its econometric identification is vulnerable to reverse causality and omitted variable biases. We address the loop's endogenous nature and isolate the direct bank-to-sovereign distress channel by exploiting the global, non-Eurozone related variation in banks’ stock prices. We instrument banking sector stock returns in the Eurozone with exposure-weighted stock market returns from non-Eurozone countries and take further precautions to remove Eurozone-related variation. We find that the transmission of instrumented bank distress to sovereign distress is around 50% smaller than the corresponding coefficient in the unadjusted OLS framework, confirming concerns on endogeneity. Despite the smaller relative magnitude, increasing instrumented bank distress is found to be an economically and statistically significant cause for rising sovereign fragility in the Eurozone.

Suggested Citation

  • Böhm, Hannes & Eichler, Stefan, 2020. "Avoiding the fall into the loop: Isolating the transmission of bank-to-sovereign distress in the Euro Area," Journal of Financial Stability, Elsevier, vol. 51(C).
  • Handle: RePEc:eee:finsta:v:51:y:2020:i:c:s1572308920300620
    DOI: 10.1016/j.jfs.2020.100763
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    More about this item

    Keywords

    Sovereign-bank loop; Bank distress; Instrumental variable estimation; Bank exposures;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • F3 - International Economics - - International Finance
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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