Based on the economic literature, various policy measures and institutions in the product and labor markets that increase growth and employment are studied. From a cross-country approach, this study finds a significant relationship between Vertical Fiscal Imbalances (VFIs) and fiscal performance in OECD countries. Different measures of vertical imbalance are used. To assess the impact of a vertical gap, a panel equation is estimated that is related to general government primary balance to vertical balance, spending decentralization, covariates, and interaction terms.

Abstract

Based on the economic literature, various policy measures and institutions in the product and labor markets that increase growth and employment are studied. From a cross-country approach, this study finds a significant relationship between Vertical Fiscal Imbalances (VFIs) and fiscal performance in OECD countries. Different measures of vertical imbalance are used. To assess the impact of a vertical gap, a panel equation is estimated that is related to general government primary balance to vertical balance, spending decentralization, covariates, and interaction terms.

IV. The Link between Sovereign And Banking Risks in Italy1

Italian and other euro area banks’ CDS spreads have moved closely with sovereign spreads since the beginning of the global financial crisis, possibly reflecting changes in international investors’ risk appetite. Starting at the end of April 2010, with the escalation of the European sovereign debt crisis, Italian banks’ CDS spreads and security yields have increased more than other euro area banks’ CDS spread and bond yields. These relative movements are found to be partly explained by changes in Italian sovereign spreads. Therefore, fiscal discipline would have a positive effect on banks’ risk profile and funding costs.

A. Introduction

1. Italian banks weathered the 2008-09 global financial crisis relatively well. Thanks to a traditional business model based on on-balance sheet lending-deposit activity and a sound supervisory framework, they did not suffer from abrupt losses. Liquidity remained adequate and, unlike elsewhere, Italian banks used limited government support.

2. However, spillovers from market turbulence related to the European sovereign debt crisis have affected Italian banks’ CDS spreads, stock prices, and bond yields. While Italy’s stock prices have fallen by about 4 percent since end-October 2009, banks’ equity prices have suffered particularly heavy losses. The five largest banks’ equity prices have plunged by over 30 percent on average from end-October 2009 to mid-May 2011, and their CDS spreads have shot up by almost 100 basis points (bps) over the same period. Italian banks’ bond yields have climbed by about 100 bps since early April 2010.

3. At the same time Italian sovereign spreads widened considerably after the Greek and especially the Irish crisis, reaching pre-euro levels. During the spring of 2010, as the Greek crisis was unfolding, sovereign spreads increased abruptly mostly because German yields declined. However, the Irish crisis led to an increase in both Italy’s government bond spreads and yields. Overall, 10-year sovereign bond yields rose from around 370 basis bps in mid-October 2010 to 460 bps in mid-May 2011. After peaking at almost 200 bps in late November 2010 and early January this year, government bond spreads in mid-May 2011 were around 150 bps, well above pre-Greek crisis levels.

4. This paper analyses the link between sovereign risks and Italian banks’ CDS spreads and bond yields. Section B reviews movements in banks’ CDS and sovereign spreads for Italy and other Euro area (EA) countries. Section C estimates a model of the determinants of changes in Italian Banks’ CDS spreads relative to a comparison group of EA banks’ CDS spreads. Section D analyzes the impact of sovereign risks on bank bond yields. Section E concludes and draws policy implications.

B. Banks’ CDS and Sovereign Spreads: Stylized Facts

5. while Italian banks’ CDS spreads have been volatile since the onset of the global financial crisis, they have increased especially starting in the spring 2010. The average CDS spreads of the five largest Italian banks, which had closely tracked the Itraxx Europe senior financial index spreads throughout the global financial crisis, have been higher than then Itraxx index spreads since the past summer. Since then the five largest Italian banks’ CDS spreads have also been widening more than the average CDS spreads of the largest EA banks.

A04ufig01

Italian, Euro Area Ban ks’ CDS, and Itraxx Spreads

(Basis points)

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A004

Sources: Bloomberg and IMF staff calculations.1/ Simple average of individual banks CDS spreads.2/ The selected sample of euro area banks includes Erste, Raiffesein, Dexia, Fortis, KBC, BNP Paribas, Credit Agricole, Societe Generale, Natixis, Deutsche Bank, Commerzbank, ABN Amro, Rabobank, ING Group.

6. Italian banks CDS spreads have moved closely with Italy’s sovereign CDS and bond spreads since the beginning of the global financial crisis. Sovereign and banks’ CDS spreads have been highly correlated especially during periods of financial stress. When spreads were low in the pre-crisis period, the correlation between changes in banks’ CDS spreads and changes in the spread of the 10-year Italian government bond over the Bund was small (0.04 during the period January 1, 2006-June 30, 2007). Instead the correlation between the two series increased to 0.5 during July 1, 2007-February 28, 2011.

A04ufig02

Italy: Banks’ and Sovereign 5-year CDS Jan. 1, 2007-May 23, 2011 1/

(Basis points)

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A004

Sources: Bloomberg; and IMF staff calculations.1/ Five largest banks average CDS spreads.
A04ufig03

Italy: Banks’ and Sovereign 5-year CDS 1/

(Basis points)

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A004

7. Co-movements among banks’ CDS and sovereign bonds or CDS spreads have been significant also for other EA countries and banking institutions over the same period. Throughout the global and European debt crisis, peaks in banks’ CDS and sovereign spreads usually coincided, in concomitance with major international event, such as the Bear Sterns’ crisis, Lehman Brothers’ bankruptcy, and the announcement of the Greek program.

A04ufig04

Selected Euro Area Banks’ CDS Spreads and Sovereign Spreads 1/

(Basis Points)

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A004

Source: Bloomberg.1/ 10-year government bond spreads over the Bund.

8. The correlation between banks’ CDS and sovereign spreads movements could be due to different reasons. Following the start of the global crisis, weakness in the financial sector may have become a factor in driving sovereign spreads, especially for governments that committed large public resources to support and guarantee financial institutions (Mody, 2009; Sgherri and Zoli, 2009).2 On the other hand, shocks to sovereign bond yields and spreads could have an impact on banks’ risk profile through different channels. Rating agencies cap bank ratings on the basis of the sovereign rating, thus creating a link between the two. Banks’ funding costs tend to rise with government bond yields, trimming down their profitability. Moreover, the decline in government bond prices reduces the value of government securities in the banks’ trading book, and even in the banking book if banks need to sell part of the securities before maturity to obtain liquidity. Furthermore, a sovereign with a heightened risk profile has a limited ability to provide support to the banking system, if needed, and makes the banking system appear riskier. A third possible explanation for the correlation between banks’ CDS and sovereign spread movements is that risk repricing may have contributed to the widening of both banks’ and sovereign risk premium differentials at the same time, in a sign of discrimination among different classes of default risk.

9. The literature on contagion has indeed shown how risk repricing due to changes in investors’ risk appetite can transmit shocks across financial instruments. During periods of financial stress (e.g., the 1997 Asian crisis, the Russian and Long-term Capital management crisis in 1998) spreads widen concurrently. A possible reason is that conditions in financial markets affect international investors’ risk appetite—the willingness of each investor to bear risk—and changes in the latter may spread the original shock across financial instruments.3

10. A principal component analysis indicates that movements in EA banks’ CDS and sovereign spreads are largely driven by a common factor. Indeed, over 70 percent of the variance in the EA banks’ CDS and sovereign spreads series analyized is explained by the first principal component.4 The loadings, representing the contribution of the individual series to the first principal component, are all positive and similar in size, suggesting that the latent factor might be capturing a common risk indicator. The estimated unobserved factor peaked at the time of enhanced strains in the interbank market in the summer of 2007 resulting in widening euro Libor-OIS spreads,5 around the Bear Sterns’ bailout, after Lehman Brothers’ bankruptcy, in early 2009, and at the time of the Greek and Irish crisis. Until end-2009 movements in the common component appear to have been correlated with tensions in the interbank market—the trasmission channel of shocks during the first stages of the global financial crisis. Since early 2010, instead, the latent factor seems to reflect regional turbolence related to the European sovereign crisis.

A04ufig05

Common Component of Sovereign Bo nd and Banks’ CDS Spreads

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A004

Sources: Bloomberg and IMF staff calculations.

11. The correlations between Italian banks’ CDS and sovereign spreads are robust even taking into account the common risk component. Examining cross-correlations of spreads where the common risk component has been stripped out (red bars in the chart), suggest volatility spillovers between Italian banks’ and sovereign spreads for three of the largest banks.6

A04ufig06

Correlation between Italian Banks’ CDS Spreads Changes and Italian Government Bond Spreads Changes

(January 1, 2006 - February 28, 2011)

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A004

Sources: Bloombergand IMF staff calculations.

C. The Movements in Italian Banks’ CDS Spreads Relative to EA Bank CDS Spreads

12. Italian banks’ CDS spreads have recently increased compared to other EA banks’ CDS spreads. Given the common movements among euro banks’ CDS spreads, to understand how the perception of Italian banks’ risk profile has changed over time, it seems more appropiate to focus on the differential between Italian banks’ CDS spreads and the CDS spreads of other EA banks, rather than on changes in Italian banks’ CDS spreads per se. It appears that before and throughout the global financial crisis, the CDS spreads of the five largest Italian banks remained very close, and even below, those of a selected group of large EA banks.7 However, starting at the end of April 2010, with the escalation of the European sovereign debt crisis, the differential between Italian and EA banks’ CDS spreads became positive and widened. Italian banks’ CDS spread differential vis- à-vis other EA banks’ seems also to have become more correlated with Italian sovereign spreads over time. Indeed, the correlation between changes in sovereign CDS spreads and changes in the CDS spreads of the largest Italian banks relative to other EA banks was very small—0.1—during the period January 2006-end-March 2010, but it increased to 0.4 in the following period.

A04ufig07

Italian Banks’ vs. Euro Area Banks’ CDS Spreads

(Basis points)

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A004

Sources: Bloomberg and IMF staff calculations.1/ Average of the five largest Italian CDS spreads minus average of the CDS spreads of a group of euro area banks. Euro area banks in the sample are Erste, Raiffesein, Dexia, Fortis, KBC, BNP Paribas, Credit Agricole, Societe Generale, Natixis, Deutsche Bank, Commerzbank, ABN Amro, Rabobank, ING Group.

13. Against this background, an econometric model is estimated to explain movements in the CDS spreads of Italian banks relative to those of other EA banks. The sample consists of daily observations covering the period January 1, 2006-February 28, 2011. The dependent variable is 5-year CDS spreads of each of the five largest Italian banks minus the average CDS spreads of a group of EA banks.8 The explanatory variables include the lagged dependent variable and the 5-year Italian sovereign CDS spreads or the 10-year government bond spreads over the Bund (lagged).9 The bid-ask spreads of each bank’s CDS premium are also introduced among the regressors, as an indicator of liquidity of the bank’s CDS. The wider is the bid-ask spread, the higher is the liquidity risk. Additional explanatory variables are a dummy for bad news and a dummy for good news related to important international events in connection with the global and European sovereign crisis (e.g., the approval of the Irish and Greek programs).10 The implied volatility index of the German stock market (VDAX index) is used as a proxy for general risk aversion.11 The euro 3 month Libor-OIS spread is also added among the explanatory variables as a measure of counterparty risk in the interbank market. All variables are differenced, with the exception of the bid-ask spread, which is stationary. Estimates are carried out using the seemingly unrelated regression method.

14. As a variation to the basic estimation model, lagged changes in sovereign spreads are also interacted with a measure of individual bank capital, to assess whether sovereign risks have a bigger impact on institutions with lower capital levels. Specifically, the measure of bank capital is the ratio between the average tier-1 of the EA banks comparison group and the tier-1 of the individual Italian banks. Also, in an alternative model Italian government bond yields are used as regressors instead of sovereign spreads.

15. Estimates indicate that changes in sovereign spreads have had a significant impact on the CDS spreads differential of four large Italian banks respect to a group of EA banks.12 Even when a dummy variable for the period following the excalation of the Greek crisis in early May 2010 is added to the regressors, the coefficients of the sovereign spread variable remain significant, indicating that perceived hightened risk in the Italian sovereign—and not the European sovereign crisis—contributed to the increase in Italian banks’ CDS spreads relative to other EA banks’ CDS spreads. The interaction term between sovereign spreads and bank capital has also a positive and significant coefficients for four Italian banks in the sample, suggesting that that the impact of sovereign risk on bank risk is larger for institutions with relatively lower capital levels (Table 1). On the other hand, government bond yields do not have a significant impact on Italian banks CDS spreads differential. The VDAX index is found to have a statistically significant effect on the dynamics of three banks CDS, suggesting that investors demand higher credit risk premiums on some Italian banks more than other European banks when risk aversion increase. Also, bad news related to the European sovereign debt crisis have also affected some Italian banks more that other EA banks. On the other hand, tensions in the interbank market, as measured by the Libor-OIS spreads do not appear to have increased Italian banks’ CDS spreads relative to other EA banks. In some cases the good news variable is found to have positive and significant coefficient, possibly indicating that in the aftermath of positive events related to the global and European sovereign debt crisis other EA banks’ CDS spreads decline more than those on Italian banks. This may be due to the fact that other EA banks, more exposed to Greece and Ireland, may have benefited more from the positive news concerning the sovereign debt crisis.

Table 1.

Determinants of Changes in Italian Banks’ CDS Spreads Relative to Euro Area’s Banks’ CDS Spreads

article image
Source: IMF staff calculations.

D. Sovereign Risks and Bank Funding Costs

16. Italian banks’ funding costs have been rising since the spring 2010. Yields on bonds issued by the five largest Italian banks have been moving in line with the yields on bonds issued by other EA banks and with the Euribor up to early 2009.13 After then, yields on Italian banks’ securities have fallen more than those on bonds issued by the comparison group of EA banks (which excludes Greek, Irish, Portuguese, and Spanish banks). However, starting in April 2010, yields on Italian banks’ securities have been climbing. Correspondingly, the spread of Italian banks’ security yields over the Euribor tightened from early 2009 to April 2010, and widened afterwards, whereby for other EA banks the spread over the Euribor has been narrowing for almost the entire period following the peak in early 2009.

A04ufig08

Italian and Euro Area Banks’ Bond Yields 1/

(Basis points)

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A004

Sources: Bloomberg, Datastream; and IMF staff calculations.1/ Average yields of bonds issued by the five largest Italian banks, and average yieldsof bonds issued by a group of euro area banks. Euro area banks in the sample are Erste, Raiffesein, Dexia, Fortis, KBC, BNP Paribas, Credit Agricole, Societe Generale, Natixis, Deutsche Bank, Commerzbank, ABN Amro, Rabobank, ING Group.
A04ufig09

Italian and Euro Area Banks’ Bond Spreads over the 3-month Euribor

(Basis points)

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A004

17. An econometric model is estimated to assess whether movements in Italian banks’ bond yields relative to other EA banks’ security yields is driven by perceived sovereign risks. The dependent variable is the yield of each of the five largest Italian banks minus the average yield of a group of EA banks.14 The explanatory variables include the lagged dependent variable, the 5-year Italian sovereign CDS spreads or the 10-year government bond spreads over the Bund (lagged), the dummy for bad news and a dummy for good news related to important international events, the VDAX index. Lagged changes in sovereign spreads are also interacted with a measure of individual bank tier-1 capital relative to the average tier-1 of the EA bank comparison group. Again, estimates are carried out using the seemingly unrelated regression method.

18. Estimates suggest that, for the five largest Italian banks, changes in sovereign spreads have had a significant impact on the bond yield differential vis-à-vis a group of EA banks. On the other hand, the interaction term between sovereign spreads and bank capital has a positive and significant coefficient only for one of the five Italian banks in the sample. The coefficient on the VDAX index has the expected positive sign and is statistically significant for four banks. The positive and significant coefficient of the good news variable for three banks again may indicate that in the aftermath of positive events related to the global and European sovereign debt crisis the yields on bonds issued by other EA banks decline more than the yields on bonds issued by Italian banks.

Table 2.

Determinants of Changes in Italian Banks’ Bond Yields Relative to Euro Area’s Banks’ Bond Yelds

article image
Source: IMF staff calculations.

E. Conclusions and Policy Implications

19. The relation between banking and sovereign risk is very complex. Banks’ vulnerabilities may affect sovereign risks. At the same time, increasing sovereign spreads and yields may have an impact on banks’ risk profile. Also, both bank and sovereign risk premium differentials may be driven by investors’ risk repricing. Indeed, movements in EA banks’ CDS and sovereign spreads are found to be partly driven by a common component, possibly reflecting changes in international investors’ risk appetite.

20. Despite movement communalities, Italian banks’ CDS spreads have increased more than other EA banks’ CDS spreads since the escalation of the Greek crisis in April 2010. The empirical analysis presented in the paper suggests that changes in sovereign spreads have been a significant determinant of the CDS spread differential of three large Italian banks with respect to a group of other EA banks. There is also some evidence that the impact of sovereign risks on perceived bank risk is larger for institutions with relatively lower capital levels.

21. Since April 2010, yields on Italian banks’ securities have also been climbing more than those on bonds issued by other EA banks. Again, the econometric analysis indicates that changes in sovereign spreads have contributed to these relative movements. Overall, then, the analysis suggests that Italian sovereign risks have a significant impact on domestic banks. This may be due to the fact that Italian banks hold large amounts of government bonds, and also to the fact that banks’ ratings (and therefore their perceived risk profile and funding costs) are linked to that of the Italian sovereign.

22. Since the onset of the global financial crisis, and especially with the eruption of the European debt crisis, financial markets have been increasingly discriminating among government issuers by requiring higher sovereign risk premiums. The recent rebound in EA sovereign spreads differentiation is noticeable especially from a historical perspective, as it follows a prolonged period of very modest differentiation across countries between 1999 and late 2008. In fact, ever since the introduction of the single currency, the remarkable compression of sovereign risk premium differentials has raised doubts about financial markets’ ability to provide fiscal discipline across EA members.

23. Renewed investors’ discrimination among sovereign issuers, together with the empirical evidence on the impact of sovereign risks on the banking sector, are compelling from a policy viewpoint. As going forward heightened financial markets’ discrimination among sovereign issuers is likely to persist, a credible commitment to long-run fiscal discipline is essential not just to hold down government financing costs and reduce vulnerabilities, but also to contain banking risks and funding costs. Furthermore, as the analysis indicates that the impact of sovereign risks on banking risk is larger for institutions with relatively lower capital levels, shoring up banks’ capital is also important to strengthen bank resilience against sovereign shocks.

Appendix I: Construction of the Dummy Variables Capturing Good and Bad News

Bad news:

  • Bear Stearns bailout (March 14, 2008)

  • Lehman bankruptcy (September 15, 2008)

  • G-7 meeting fails to address Greek debt problem (February 7, 2010)

  • EU-IMF €45 billion program on Greece announced (April 11 2010)

  • S&P downgrades Greece and Portugal (April 27, 2010)

  • ECB disappoints expectations that it will step in to support the sovereign debt market and Moody’s Investors Service warns that European banks could be affected by the Greek banking system’s woes. (May 6, 2010)

  • French and German governments agree to take steps that would make it possible to impose haircuts on government bonds (October 28, 2010)

  • Ireland requests EU-IMF program (November 21 2010)

  • EU-IMF Irish program announced (November 28 2010)

  • EU Commission issues a consultation paper on a draft directive that would give regulators sweeping powers to restructure debts of failing banks (January 6, 2011)

Good news:

  • Italy approves a law granting the government the possibility to recapitalise distressed banks (October 8, 2008)

  • The government approves a law to inject capital into sound banks (November 28, 2008)

  • At G-20 Finance ministers meeting IMF funding is boosted (March 15, 2009)

  • Enlarged €110 bln package for Greece announced (May 2, 2010)

  • €750 bln European Financial Stability Facility is created (May 9, 2010) and the Governing Council of the ECB decides on several measures to address tensions in financial markets (Securities Markets Program and a fixed rate tender procedure with full allotment in the regular three-month longer-term refinancing operations in May and June 2010).

  • European bank stress test results are published (23 July 2010)

  • Finance ministers make clear that burden sharing would apply only to bonds issued after 2013 (November 12, 2010)

  • ECB announces that it would continue to provide exceptional liquidity support via three months financing at fixed rates with full allotment until April 2011 (December 2, 2010)

  • The European Commission says the size of the European Financial Stability Facility must be reinforced and its application expanded (January 12, 2011)

  • EA finance ministers agree to provide €500 bln for a new permanent crisis fund (European Stability Mechanism) that will come into force in 2013 (February 14, 2011)

References

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  • Dungey, M., R. Fry, B. Gonzalez-Hermosillo, and V. L. Martin, 2003, “Characterizing Global Investors’ Risk Appetite for Emerging Market Debt during Financial Crises,” IMF Working Paper 03/251, (Washington: International Monetary Fund).

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  • Dungey, M., R. Fry, B. Gonzalez-Hermosillo, and V. L. Martin, 2005, “Empirical Modelling of Contagion: A Review of Methodologies,” Quantitative Finance, 5, pp. 924.

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  • Dungey, M., R. Fry, B. Gonzalez-Hermosillo, and V. L. Martin, 2006, “Contagion in International Bond Markets During the Russian and LTCM Crises,” Journal of Financial Stability, 2, pp. 127.

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  • Dungey, M., R. Fry, B. Gonzalez-Hermosillo, and V. L. Martin, 2007, “Contagion in Global Equity Markets in 1998: The Effects of the Russian and LTCM Crises,” North American Journal of Economics and Finance, 18, pp. 155174.

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  • Dungey, M., R. Fry, B. Gonzalez-Hermosillo, and V. L. Martin, 2011, “Transmission of Financial Crises and Contagion: A Latent Factor Approach,” Oxford University Press, U.K.

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  • Gonzalez-Hermosillo, B., 2008, “Investors’ Risk Appetite and Global Financial Market Conditions”, IMF Working Paper 08/85.

  • Kumar, and Persaud, 2002, “Pure Contagion and Investors’ Shifting Risk Appetite: Analytical Issues and Empirical Evidence,” International Finance, Vol. 5, pp. 401426.

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  • Mody, A. 2009, “From Bear Sterns to Anglo Irish: How Eurozone Sovereign Spreads Related to Financial Sector Vulnerability,” IMF Working Paper, No. 108 (Washington: International Monetary Fund).

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  • Pericoli, M., and M. Sbracia, 2003, “A Primer on Financial Contagion,” Journal of Economic Surveys, 17, pp. 571608.

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1

Prepared by Edda Zoli (EUR).

2

In Ireland, for example, sovereign spreads started to climb after the government extended a guarantee to the banking system in 2008. Mody (2009) finds that while exposure to the financial sector was not an important determinant of sovereign spreads prior to the collapse of Bear Sterns in March 2008, it has become increasingly more significant as the financial crisis progressed. Sgherri and Zoli (2009) show that rising expected default frequencies (EDFs) in the financial sector translated into increases in government spreads in a number of EA countries in late 2008-early 2009.

3

Risk appetite depends on both risk aversion—a “deep” parameter measuring the subjective attitude of investors with regard to uncertainty—and the level of uncertainty itself. Work analyzing the role of risk appetite as a transmission channel of financial crises include for example Kumar and Persaud (2002), and Dungey, Fry, González-Hermosillo and Martin (2003). Papers examining how financial crises transmit across geographical borders and different asset classes comprise, among others, Dornbusch, Park, and Claessens (2000), Pericoli and Sbracia (2003), and Dungey et al. (2003, 2005, 2006, 2007, 2011).

4

The series included in the principal component analysis comprise the spreads of 10-year government bonds over the Bunds of Austria, Belgium, Finland, France, Greece, Ireland, Italy, Netherlands, Portugal, and Spain, and the 5-year CDS spreads of the following EA banks: Erste, Raiffesein, Dexia, Fortis, KBC, BNP Paribas, Credit Agricole, Societe Generale, Natixis, Deutsche Bank, Commerzbank, ABN Amro, Rabobank, ING Group, Intesa San Paolo, Unicredit, Monte dei Paschi, Banco Popolare, Unione Banche Italiane, Alpha bank, Banco Espirito Santo, Banco Comercial Portugues, Banco Popular Espagnol, Banco Santander, Banco Bilbao Vizcaya Argenta, Caja Madrid, Caixa, Allied Irish Bank, Anglo Irish, Bank of Ireland. All series were standardized before computing the principal component.

5

Libor stands for London interbank offered rates, and the OIS for overnight index swap rates. The spreads between these two interest rates is considered a measure of distress in the interbank market.

6

To strip out the common component, changes in individual banks CDS and government bond sovereign spreads were first regressed on changes in the first principal component. Then “adjusted” spreads series were computed as the difference between the original series and the common component multiplied by the estimated coefficient.

7

The EA banks included in the comparison group are Erste, Raiffesein, Dexia, Fortis, KBC, BNP Paribas, Credit Agricole, Societe Generale, Natixis, Deutsche Bank, Commerzbank, ABN Amro, Rabobank, ING Groep. The list excludes Greek, Irish, Portuguese, and Spanish banks.

8

See footnote 7 for the list of banks included in the group.

9

While the possible reverse causality between banks’ CDS and sovereign spreads is not fully solved by entering the sovereign spread as a regressor with a lag, the problem is probably not too serious in the case of Italian banks, as they have received little government financial support during the financial crisis. Also, Granger causality tests suggest that changes in sovereign spreads drive changes in individual banks’ CDS spreads relative to other EA banks, and not the other way around.

10

The Appendix provides the list of events captured by the dummies.

11

In principle the common component of banks’ CDS and sovereign spreads could be used as an indicator of risk aversion. However, given that it is highly correlated with sovereign spreads, these two variables cannot both be included as explanatory variables in the same regression.

12

Similar results are obtained regardless of whether sovereign CDS spreads are or 10-year government bond spreads to the Bund are used as regressors.

13

Portfolios of debt securities issued by Italian and other EA banks were constructed using bonds broadly comparable in terms of maturity and seniority.

14

See footnote 7 for the list of banks included in the group.

Italy: Selected Issues
Author: International Monetary Fund
  • View in gallery

    Italian, Euro Area Ban ks’ CDS, and Itraxx Spreads

    (Basis points)

  • View in gallery

    Italy: Banks’ and Sovereign 5-year CDS Jan. 1, 2007-May 23, 2011 1/

    (Basis points)

  • View in gallery

    Italy: Banks’ and Sovereign 5-year CDS 1/

    (Basis points)

  • View in gallery

    Selected Euro Area Banks’ CDS Spreads and Sovereign Spreads 1/

    (Basis Points)

  • View in gallery

    Common Component of Sovereign Bo nd and Banks’ CDS Spreads

  • View in gallery

    Correlation between Italian Banks’ CDS Spreads Changes and Italian Government Bond Spreads Changes

    (January 1, 2006 - February 28, 2011)

  • View in gallery

    Italian Banks’ vs. Euro Area Banks’ CDS Spreads

    (Basis points)

  • View in gallery

    Italian and Euro Area Banks’ Bond Yields 1/

    (Basis points)

  • View in gallery

    Italian and Euro Area Banks’ Bond Spreads over the 3-month Euribor

    (Basis points)