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The Effect of the PSI in the Relationship Between Sovereign and Bank Credit Risk: Evidence from the Euro Area

Multinational Finance Journal, 2019, vol. 23, no. 3/4, pp. 211-272
Michalis-Panayiotis Papafilis , University of Piraeus, Greece
Dimitris Margaritis , The University of Auckland Business School, New Zealand

Abstract:
This study examines the nexus between sovereigns and banks during a crisis with a focus on the effects of PSI, the voluntary exchange program of Greek sovereign bonds with private sector involvement. The effectiveness of the program is evaluated through its impact on credit default swaps of 8 Eurozone countries and 21 banks, using daily data from 2009 to 2014. Using linear and nonlinear causality analyses, it is found that the link between sovereign and bank risk weakened after PSI, while the persistence and magnitude of lead-lag interactions also declined in the same period. A difference-in-difference model confirms this result. The findings are also robust to second moment filtering, with GARCH-BEKK residuals indicating the presence of significant albeit declining nonlinear causal effects. The empirical evidence suggests that sovereign debt restructuring initiatives, such as PSI, could be an effective policy measure to ease off pressure on the nexus between banks and their sovereigns.

Keywords : CDS spreads; PSI; sovereign/bank credit risk; contagion; nonlinear causality
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