Purpose of the study
The objective of this thesis is to study whether changes in European sovereigns’ credit spreads affect credit spreads of local banks and firms, and the other way around. European banks and sovereigns have been proven to be interconnected through spillovers of credit risk during crisis periods (Acharya et al., 2014). The aim of this study is to test whether recently introduced regulation and the European Banking Union have been able to break the link that is harmful for the stability of the financial sector and to European economies. In addition, I study whether a similar connection of credit spreads exists between non-financial firms and sovereigns as well, a relation that is scarcely discussed in existing literature.
Data and methodology
The sample consists of a panel dataset of credit default swap spreads of 14 European sovereigns, 31 banks and 113 non-financial companies between January 2009 and June 2017. Historical CDS data is fetched from Datastream and control variables from several sources. Changes in the relation between sovereign and corporate credit spreads is studied with linear panel regressions on daily changes in CDS spreads, controlling for market movements and day and firm fixed effects. The sample is divided into four sub-periods to test whether regulatory improvements have decreased the co-movement between credit spreads. In addition, several interaction variables are added to the regression models to test for the existence of different channels of credit risk transfer.
Findings
The results show a two-way dynamic between sovereign and corporate credit risk in Eurozone countries. Changes in sovereign CDS spreads significantly affect firm CDS spreads over and above market movements and firms’ own equity returns, while sovereign spreads are also meaningfully affected by changes in the private sector’s credit risk. The findings differ meaningfully between studied sub-periods, and the two-way relation between financial sector and sovereign spreads diminishes after 2014. Effects for the non-financial sector are more persistent, but economically smaller.
In addition, I find that banks and firms are more affected by sovereign credit risk if they are likely to receive government support, or have a credit rating close to the sovereign rating. Banks holding large amounts of domestic bonds and firms that are more dependent on bank financing are also more vulnerable to sovereign risk
