Sovereign Risk and Banking Stability: A Two Way Avenue

Abstract

The study aims at investigating the interplay between the sovereign risk and the banking stability, by constructing a financial satellite based on systems of simultaneous equations method. The econometric results confirmed that the quality of banking book is highly sensitive to CDS rate developments. Additional challenges could be raised via the net interest income channel, as empirical findings suggest a higher sensitivity of interest expenses to changes in sovereign risk than that of interest income. Furthermore, the risk of entering into a vicious spiral is not negligible, since material feedback effects from banking stability to sovereign risk were identified. The analysis highlighted also a possible similarity of pass-through features between the CDS rate and policy rate on money market interest rates, in terms of both impact interval and level. One policy implication would perhaps be to add the CDS rate among the macro-stability indicators, and consequently to develop a structured and permanent CDS targeting process. This study made also an attempt in this direction, taking into consideration both internal fundamentals and possible regional contagion effects.
Keywords: Banking stability, CDS rate, Net interest margin, Nonperforming loans ratio, Sovereign risk.