The eurozone crisis:how banks and sovereigns came to be joined at the hip

Ashoka Mody and Damiano Sandri

Presented by Caterina RhoMay 15, 2013

Outline• Introduction

▫Financial crisis and sovereign default

• Theoretical Model

• Data and econometric approach

• Results

• Comments

• Conclusion

Introduction• Empirical analysis of the link between financial crisis and fiscal

crisis in Eurozone in the period 2007-2011.

• Reinhart and Rogoff (1999): twin crisis, the fiscal crisis follows the financial crisis without backward effect.

This paper: the public debt crisis and the financial crisis mutually reinforce.

• Two level of analysis:▫ General panel data analysis▫ Contry level analysis

• Beginning of European crisis: nationalizaton of Anglo-Irish Bank.

Timing of the crisis• July 2007: subprime crisis. The risk premia on

sovereign bonds in EZ countries rise homogenously through EZ in line with global trends.

• March 2008: rescue of Bear Stearns, beginning of a separate European crisis. Sovereign spreads started to respond to the weaknesses of their own financial sectors.

• January 2009, May 2010 : nationalization of Anglo-Irish bank and Greek sovereign crisis. Sovereign weaknesses started to be transmitted to the financial sector. Potential for mutual destabilization.

Increase and dispersion of Eurozone sovereign spreads (bps)

Theoretical model (1)• Two period model

• Agents: government, banks, private investors.

• Period 1: the government issues a stock of bonds guaranteeing a rate of return , the exogenous risk-free rate.

• Period 2: the government repays the debt subject to the budget constraint:

▫ : the debt/GDP ratio can’t exceed a default threshold.▫ with and country specific ▫ : the level of capital investment is determined by the

financial sector.

Theoretical model (2)• Government budget constraint:

• Condition on sovereign interest rate:

▫ is country specific.

If a negative shock occurs, the debt/GDP ratio rises.

If rises, also the default probability and the spread will rise.

Data and econometric approach (1)• Data:

▫ weekly changes in spread of sovereign bonds▫ 10 countries in the Eurozone▫ From January 2006 to November 2011

• Elements of the analysis:

▫ The sovereign spread : difference between the secondary market yield on the country 10-year bond and the yield on German bund

▫ An high-frequency measure of financial sector expectations, :

Expectations of the financial sector and the sovereign spreads

Data and econometric approach (2)

Lags of spread

Lags of financial weakness index

Controls Country f.e.

LB dummy

Data and econometric approach (3)•Analysis of the determinants of the changes in

sovereign spreads before and after Anglo-Irish bailout.

•Granger-Causality test for reverse causality:

•Test for country differences.

Results•Pre-Anglo period:

▫Until 2007: the changes in spreads are random.▫2007-Bear Stearns: changes due to global

factors.▫Bear Stearns-Anglo Irish: changes due to

domestic financial markets.

•Post-Anglo period: ▫Contemporaneous correlation between

financial stress and rise in sovereign spreads.▫Rising of eurozone risk.

Phase 1: changes in spreads before Anglo Irish

Phase 2: changes in spreads after Anglo-Irish

Country differences by growth prospects

Country differences by fiscal position

CommentsAlternative to Bear Stearns: Northern Rock, Greece bailout

Conclusion• Empirical study about how the financial

component and the fiscal component are intertwined in the Eurozone crisis.

• Analysis of the relationship between financial stress and sovereign yield spreads.

• Simple explanation of a complex problem▫Too simple? Various interpretations of the timing

and dynamics of the European crisis.▫Difficult to establish causality

References• Kaminsky, G. and C. Reinhart. 1999. “The TwinCrises: The Causes of Banking and Balance of Payments Problems.” American Economic Review 89: 473–500.

• Kliesen, K. and D. C. Smith: “Measuring financial market stress” Economic Synopses, Federal Reserve Bank of St. Louis, 2, 2010

• Mody A. and D. Sandri: “The eurozone crisis: how banks and sovereigns came to be joined at the hip” Economic Policy, 27, 70: 199-230, April 2012