niccolò battistini - csef · niccolò battistini rutgers university marco pagano university of...

Motivations Preview of results Factor decomposition Sovereign portfolios Conclusions

SYSTEMIC RISK, SOVEREIGN YIELDS AND

BANK EXPOSURES IN THE EURO CRISIS

Niccolò Battistini

RUTGERS UNIVERSITY

Marco Pagano

UNIVERSITY OF NAPLES FEDERICO II, CSEF AND EIEF

Saverio Simonelli

UNIVERSITY OF NAPLES FEDERICO II AND CSEF

April 20, 20141 / 30


This paper

I Focus on the European sovereign debt crisis.I Sovereign default risk or euro breakup risk?I How do bank portfolios react to these two risks?I Policy implications.

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Risk of euro breakup?

(a) 20 November 2010 (b) 4 December 2010

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Risk of euro breakup? (cont.)

(c) 16 July 2011 (d) 17 September 2011

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Risk of euro breakup? (cont.)

I Nouriel Roubini:“Greece will leave the eurozone in the next 12 months, andPortugal after. . . There is a 50% chance that the eurozone willbreak up in the next 3 to 5 years” (January 2012).

I Mario Draghi:“the premia that are being charged on sovereign statesborrowings . . . have to do more and more with convertibility,with the risk of convertibility” (26 July 2012).

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percen

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total assets of banks

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Objective

I Final objective: understand how default risk and redenominationrisk affect banks’ sovereign exposures.

I Preliminary step: decompose sovereign yields incountry-specific component (default risk) and a commoncomponent (euro breakup risk).

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Preliminary step: systemic vs. country risk

I Our method: Dynamic factor model.I Previous literature: Identification of systemic risk via principal

component (Ang and Longstaff, 2011) or observables (Attinasi etal, 2009; De Santis, 2012; Di Cesare et al., 2013; Caceres et al,2010; Sgherri and Zoli, 2009; Giordano et al, 2012).

I Result 1: The common factor correlates with euro breakup risk.I Result 2: Increase in the euro-area yields (relative to the swap

rate) mainly reflects country specific risk.I Result 3: CDS premia also reflect systemic risk, especially in

core countries.

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Final objective: home bias in banks’ sovereign portfolios

I Our method: Vector error correction model using (observed)aggregate banks’ exposures and (country/common) yielddifferentials.

I Previous literature: (estimated) banks’ exposures suggest carrytrades especially by periphery banks (Acharya and Steffen,2012).

I Result 1: higher country-specific risk =⇒ periphery banksincrease domestic exposure, core banks reduce it;

I Result 2: greater common risk =⇒ all banks increase domesticexposures.

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This paper


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Systemic vs. country riskThe model

I To illustrate the dynamic factor model, consider the case of 2countries:

∆y1t

∆p1t

z1t

∆y2t

∆p2t

z2t

xt

=

α1G α1C 0α2G α2C 0α3G α3C 0α4G 0 α4C

α5G 0 α5C

α6G 0 α6C

α1 0 0

fGt

f1t

f2t

+ ξt ≡ Λft + ξt,

I f Gt is a global common factor, f1t and f2t are the country-specific

factors;I Λ is the matrix of factor loadings;I ξt is the vector of idiosyncratic errors

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Systemic vs. country risk (cont.)

The modelI The latent factors are assumed to have an autoregressive

structure:

ft = A(L)ft−1 + ut,

where A(L) is diagonal with two lags, so that the factors areorthogonal.

I The common and country-specific factors are estimated via atwo-step procedure (see Doz et al., 2011).

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Global Factor Google trend

Google Trends index measures how often search-terms related tothe collapse of the euro were entered in the Google searchengine.

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Global Factor Intrade prob(euro breakup)

The probability that any country that used the Euro as of March12th, 2008 would announce its intention to drop the Euro beforethe end of 2013, based on Intrade data.

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Variance decomposition: yield differentials relative to the swap rate

Common Country IdiosyncraticAustria 0.05 0.86 0.09Belgium 0.17 0.45 0.38Germany 0.36 0.32 0.32Spain 0.21 0.72 0.07France 0.01 0.95 0.04Greece 0.03 0.27 0.69Ireland 0.00 0.34 0.66Italy 0.29 0.74 —Netherlands 0.04 0.92 0.04Portugal 0.01 0.83 0.16Denmark 0.02 0.97 0.01

I Result 2: Increase in the euro-area yields mainly reflects countryspecific risk (except for Germany).

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Variance decomposition: CDS premia

Common Country IdiosyncraticAustria 0.67 0.15 0.19Belgium 0.56 0.17 0.27Germany 0.60 0.07 0.33Spain 0.43 0.47 0.10France 0.65 0.04 0.31Greece 0.05 0.61 0.34Ireland 0.13 0.21 0.66Italy 0.59 0.35 0.06Netherlands 0.49 0.06 0.45Portugal 0.11 0.73 0.16Denmark 0.56 0.01 0.58

I Result 3: CDS premia also reflect systemic risk, especially incore countries.

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Common and country components of the Italian yield differential andCDS premium

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Common and country components of the German yield differential andCDS premium

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This paper


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Home bias in banks’ sovereign portfolios

Why this form of home bias may increase in response to higherdomestic sovereign debt yields?

1. High-risk sovereign issuers may exert “moral suasion” on “their”banks to buy domestic sovereign debt in time of stress.

2. Undercapitalized banks, most in periphery countries, may bet forresurrection by engaging in “carry trades” (Acharya and Steffen,2012).

3. Domestic banks are better hedged against the redenominationrisk of domestic sovereign debt than foreign banks.

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Home bias in banks’ sovereign portfolios: the model

I For each country in the sample, the estimated VECM model canbe represented as follows:

∆yt = α[β′yt−1 + γ dt−1

]+ Θ ∆yt−1 + Γ ∆Dt + ut,

I where yt =[spreadt sovexpt

]′ in the baseline model andyt =

[commont countryt sovexpt

]′ in the factor-based model;I α and β are the matrices of adjustment and cointegrating

parameters, respectively;I dt and Dt are vectors of restricted and unrestricted deterministic

variables, respectively.

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Home bias in banks’ sovereign portfolios: results

Unconditional evidenceI In almost all countries banks increase their domestic exposures

in response to an increase in domestic yields.

Conditional evidence (country/systemic shocks)I In most periphery countries banks respond to increases in the

country risk factor by raising their domestic exposure, while incore countries they do not.

I In almost all countries banks increase their domestic exposuresin response to an increase in the common risk factor.

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Home bias in banks’ sovereign portfolios: results (cont.)

0 2 4 6 8 10 12 14 16 18 20!0.1

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Home bias in banks’ sovereign portfolios: results (cont.)

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Home bias in banks’ sovereign portfolios: interpretation

I Country shock:For periphery-country banks only, the evidence supports the“moral suasion” and/or the “carry-trade” hypothesis.

I Common shock:Increased risk of euro collapse and currency redenomination hasincreased the home bias of banks, especially in core countries.

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This paper


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Policy Implications

I Moral suasion could be tempered by shifting prudentialsupervision from national to supranational level (SSM).

I Carry trades by banks could be discouraged by change inprudential regulation: (i) positive risk weights on sovereign debtand/or (ii) limits on the concentration on sovereign debt.

I The home bias due to banks’ comparative advantage in dealingwith redenomination risk can only be addressed by reducing theprobability of euro breakup (Draghi’s 2012 speech, OMT).

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niccolò battistini - csef · niccolò battistini rutgers university marco pagano university of...

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