Sovereign, Bank and Insurance Credit Spread: Connectedness and System Networks

The risk of the banking and insurance system has become an important element in the determination of sovereign risk and vice-versa. The authors apply several econometric measures of connectedness based on Granger-causality networks to the changes of sovereign risk of European countries and credit risk of banks and insurances. Sovereign and credit risk are measured both using Credit Derivative Swaps and the Merton model (the Contingent Claim Analysis) applied to risk-adjusted balance sheet, which shows the sensitivity of the enterprise's assets and liabilities to external "shocks." The aim of the project is to highlight connections (explicit and implicit, linear and non-linear) among countries and institutions to quantifying the effects of asset-liability mismatches within and across countries and financial institutions. We moreover compare expected loss ratios with actual CDS prices for different financial institutions and countries and isolate channels that affect CDS: implicit guarantees and spillovers from sovereigns. Particular attentions will be dedicated to determine a new measure for sovereign risk based on economic variables rather than CDS market information. The complex interactions, spillovers and feedbacks of the global crisis that began in 2007 remind us how important it is to improve our analysis and modeling of financial crises and sovereign risk. With this project we aim to examine how vulnerabilities can build up and suddenly erupt in a financial crisis with potentially disastrous feedback effects for sovereign debt and economic growth. Traditional macroeconomic analysis overlooks the importance of risk, which makes it ill-suited to examine interconnectedness and transmission mechanisms in response to common shocks. Using contingent claims analysis (CCA) and network theory we propose new ways to measure and analyze financial system, sovereign, and credit risks.

The acquisition and management of the data is done. A working paper “Sovereign, Bank and Insurance Credit Spreads: Connectedness and System Network“ is in progress and has been presented at several occasions.