Does Bank Systemic Risk Influence Sovereign Bond Spread?

Romora Edward Sitorus

Sampoerna School of Business, Sampoerna University

October 26, 2015

Abstract:

This study investigates the exposure of Asian countries’ sovereign bond spread to bank systemic risk shocks over the period 2000-2013. I find that greater bank systemic risk predicts higher sovereign bond spread, after controlling for country-specific, regional, and global factors. I further find that this relation is tempered by country’s institution quality and economic freedom. In contrast, commonality in trading activity is positively associated with greater bank systemic risk, and hence higher sovereign bond spread. These results remain unchanged for various robustness checks.

Does Bank Systemic Risk Influence Sovereign Bond Spread? – Introduction

Understanding the sources of sovereign bond spread is important for several reasons. First, sovereign bond spread acts as benchmark for various types of interest rate in economy (Gande and Parsley, 2005). Second, sovereign bond spread provides information about the default risk of a country (Eichengreen and Moody, 2001; Lane, 2012). Third, understanding the determinant of sovereign bond spread is essential for policy makers to anticipate the shocks that may affect the sovereign debt market (Edwards, 1984; Eichengreen and Moody, 1998). Finally, Dewachter et al. (2015) argue that convergence of the sovereign bond spread in a region could reflect the level of regional economic integration (e.g. the birth of European Economic and Monetary Union in 1999 has led to an unprecedented convergence of sovereign bond spread).

A large and growing literature has attempted at explaining the determinants of sovereign bond spread. Recent works documents that credit and liquidity risk premium are important sources of sovereign bond spreads (Gomez-Puig, 2006; Beber et al., 2009; Favero et al., 2010). On the one hand, credit risk premium can be defined as the financial compensation demanded by investors if a government default on its bonds and thus investors could not get their full investment and interest. On the other hand, liquidity risk premium refers to the extra interest rate that investors require to cover the risk of having to sell their bond at lower price when it is sold immediately (Manganelli and Wolswijk, 2009).

Prior works have stressed that traditional country-specific and region-specific variables alone cannot explain the pricing of sovereign bond risk (Mody, 2009; Allen et al.,2011). In particular, some studies show that international risk factors and global investors’ risk aversion contribute significantly to sovereign bond yield differential among countries (Codogno; 2003; Geyer et al., 2005; Favero et al., 2010). However, little is known about the link between domestic financial market fragility and sovereign bond spread and even less about the relation between the domestic banking sector stability and sovereign bond spread.

In the aftermath of 2008 global financial crisis, some works have explored the link between systemic risk and sovereign risk. For instance, several studies document that the surge in sovereign bond spreads in the euro area is positively associated with risk and vulnerability banking sector in Euro area countries, especially Portugal, Italy, Ireland, Greece and Spain (Beirne and Fratzscher, 2013; Alter and Beyer, 2014; Augustin, 2014; Monfort and Renne, 2013). The increasing concerns about the solvency national banking system and their budgetary consequences could have significant role in explaining movements of sovereign bond yield differentials. Specifically, systemic risk increases fiscal vulnerabilities and default risk concerns, leading to shift of investor risk appetite – the willingness of each investor to bear risk – and thus the risk is manifested into sovereign risk premium. This notion is corroborated by Altern and Schuler (2012) who find that sovereign credit risk is strongly influenced by the movement of bank CDS spread in several European countries between 2007 and 2010. In parallel, some theoretical frameworks of the link between systemic risk and sovereign credit risk have also been constructed by Gray et al. (2007) and Acharya et al. (2014).

Though this study argues that bank systemic risk may affect sovereign bond yield in a similar way with the effect of banking credit risk on sovereign credit risk, this study does not conjecture that bank systemic risk is equal to bank credit risk. The reason for this argument is that systemic risk measure in this study is the correlation of bank idiosyncratic risk, which is different from bank credit risk. The correlation of bank idiosyncratic risk is not directly affected by the financial sector’s implicit and and explicit guarantee and holdings of sovereign bonds. Consequently, this study excludes the possibility of two-way feedback effect or endogeneity problem between bank systemic risk and sovereign bond yield, unlike the presence of feedback loop between financial sector and sovereign credit risks in the work of Acharya et al. (2014). In contrast, this study focuses on showing and verifying empirically the presence of a one-way effect between bank systemic risk and sovereign bond yield spread.

Sovereign Bond Spread

Sovereign Bond Spread

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