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The eurozone crisis:
how banks and sovereigns came to
be joined at the hip
Ashoka Mody and Damiano Sandri
Presented by Caterina Rho
May 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 AngloIrish 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 𝐵1 guaranteeing a
rate of return 𝑟 > 𝑖 , the exogenous risk-free rate.
• Period 2: the government repays the debt subject to the budget
constraint:
𝐵1 1 + 𝑟
𝑏2 =
𝑌2
▫ 𝑏2 < 𝑏: the debt/GDP ratio can’t exceed a default threshold.
▫ 𝑌2 = 𝐴1 1 + 𝑔 𝐾1 𝜀2 with log 𝜀2 ~𝑁 0, 𝜎 and country specific 𝑔
▫ 𝐾1 = λ𝐸1 : the level of capital investment is determined by the financial
sector.
Theoretical model (2)
• Government budget constraint:
𝐵1 1 + 𝑟
𝑏2 =
𝐴1 1 + 𝑔 𝐾1 𝜀2
• Condition on sovereign interest rate:
1 − 𝐷 1 + 𝑟 + 𝐷𝜇 1 + 𝑟 = 1 + 𝑖
▫ 𝐷 is country specific.
 If a negative shock 𝜀2 occurs, the debt/GDP ratio 𝑏2 rises.
 If 𝑏2 rises, also the default probability 𝐷 and the spread
𝑟 − 𝑖 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 𝑆𝑖𝑡 : 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,
𝐹𝑖𝑡 :
𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑠𝑒𝑐𝑡𝑜𝑟 𝑒𝑞𝑢𝑖𝑡𝑦 𝑖𝑛𝑑𝑒𝑥
𝐹𝑖𝑡 =
𝑜𝑣𝑒𝑟𝑎𝑙𝑙 𝑒𝑞𝑢𝑖𝑡𝑦 𝑖𝑛𝑑𝑒𝑥
Expectations of the financial
sector and the sovereign spreads
Data and econometric approach (2)
𝑝
𝑝
∆𝑆𝑖𝑡 = 𝛼 +
𝛽1,𝑡−𝑠 ∆𝑆1,𝑡−𝑠 +
𝑠=1
Lags of
spread
𝑝
λ1,𝑡−𝑠 ∆𝐹1,𝑡−𝑠 +
𝑠=0
𝜑1,𝑡−𝑠 ∆𝑍1,𝑡−𝑠 + 𝛿𝑖 + 𝐷𝑡 +𝜀𝑖,𝑡
𝑠=0
Lags of
financial
weakness
index
Controls
Country LB
f.e. 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:
𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑤𝑒𝑎𝑘𝑛𝑒𝑠𝑠 → 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑠𝑜𝑣𝑒𝑟𝑒𝑖𝑔𝑛 𝑠𝑝𝑟𝑒𝑎𝑑𝑠
𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑜𝑣𝑒𝑟𝑒𝑖𝑔𝑛 𝑤𝑒𝑎𝑘𝑛𝑒𝑠𝑠 → 𝑓𝑎𝑙𝑙 𝑖𝑛 𝑖𝑛𝑣𝑒𝑠𝑡𝑜𝑟𝑠′ 𝑒𝑥𝑝𝑒𝑐𝑡𝑎𝑡𝑖𝑜𝑛𝑠
• 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
Comments
Alternative 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 Twin
Crises: 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