On the Nexus between Sovereign Risk and Banking Crises

The sovereign debt crisis in the euro area highlighted the close connections between the financial health of banks and sovereigns and was associated with higher funding costs and lower private sector credit. In this study, we analyse the dynamics of the co-movement between sovereign and bank credit default swaps (CDS) spreads over five sub-periods over 2010-2018 and evaluate the effects of the announcement and introduction of the Single Resolution Mechanism (SRM). Our evidence demonstrates that the new bail-in regime, which ensures that troubled banks’ private debtholders absorb their losses first, before public money could be used to bail them out, significantly reduced the interconnections between sovereign and banking sector risks.