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Financial Sector Linkages and the Dynamics of Bank and Sovereign Credit Spreads

by René Kallestrup of Copenhagen Business SchooL,
David Lando of Copenhagen Business SchooL, and
Agatha Murgoci of Copenhagen Business SchooL

July 12, 2011

Abstract: We propose two risk measures for capturing cross-border contagion in the banking system based on country-speci c statistics for the composition of banks' aggregate balance sheets. The measures help explain the dynamics of bank CDS premia after controlling for country speci c and global risk factors. The rst measure uses information on the relative size and riskiness of aggregate exposures of banks in one country to non-nationals, i.e. the public sector, bank and non banks, in other countries. The other measure combines the rst measure with information on the relative size and riskiness of exposures to domestic government bonds and other domestic residents. We also shed new light on the contribution of bank guarantees to sovereign risk.

JEL Classification: G01,G15,G21.

Keywords: Credit risk, banks, sovereign risk.

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