Sovereign and bank solvency risks

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Title: Sovereign and bank solvency risks
Author: Peltonen, Juho
Other contributor: Helsingin yliopisto, Valtiotieteellinen tiedekunta, Politiikan ja talouden tutkimuksen laitos
University of Helsinki, Faculty of Social Sciences, Department of Political and Economic Studies
Helsingfors universitet, Statsvetenskapliga fakulteten, Institutionen för politik och ekonomi
Publisher: Helsingin yliopisto
Date: 2017
Language: eng
Thesis level: master's thesis
Discipline: Kansantaloustiede
Abstract: The Euro crisis 2009–2012 made sovereign debt a significant problem in many European countries, which was a significant change to the prevailed thought that the sovereign debt of developed country is a safe asset. The increase in sovereign default risk was recognized to be in close connection with the banking sector credit risk. This thesis explains the relationship of sovereign and bank credit risk, a phenomenon called “the feedback loop”. The feedback loop occurs between the sovereign and banks when the deterioration of sovereign creditworthiness reduces the market value of banks’ holdings of sovereign debt. The value reduction decreases the solvency of banks and in the worst case leads to insolvency, which requires the sovereign to bail out the banks. This in turn induces negative feedback to the sovereign increasing risk and reducing the market value of the sovereign debt even further, creating a self-perpetuating loop. The formal mathematical model of the feedback loop is presented in this thesis. First a one-country model, which is then extended to a two-country model. Using these models, the channels linking the sovereign and banks together, as well as the factors affecting the occurrence of the feedback loop can be examined in detail. Further, I create a model of a banking union, based on the two-country model. The proposed model shows how the banking union can prevent the feedback loop. The banking union model is also used to study issues affecting the design of the banking union, like the limits of its costs and resources. The analysis reveals, that when banks' equity and a sovereign fiscal surplus are low, and banks are exposed to sovereign debt, a drop in a value of sovereign debt leads to a feedback loop. The twocountry model shows that the feedback loop can also be the result of a price drop of foreign debt and that risk contagion can occur between countries. Banks may also be exposed to part of the sovereign debt risk without direct holdings, through their holdings of the foreign sovereign debt. In addition, the role of banking union, which is responsible for bailing out banks instead of the sovereign, is studied with the two-country model. The feedback loop can be prevented by requiring banks to hold sufficient amounts of equity relative to their sovereign exposures. Furthermore, the banking union removes the link between banks and the sovereign, preventing the feedback loop from starting. However, the banking unions success is dependent of the design of the union, and may in cases of too small resources lead to worse situation in member states than without the union.
Subject: Sovereign debt
Feedback loop
Banking union
Bank insolvency
Sovereign default
Euro crisis

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