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Systemic Risk and Home Bias in the Euro Area

Niccolò Battistini (), Marco Pagano () and Saverio Simonelli

No 494, European Economy - Economic Papers 2008 - 2015 from Directorate General Economic and Financial Affairs (DG ECFIN), European Commission

Abstract: According to conventional indicators, the euro-area financial integration has receded since 2007, mainly in the money market, sovereign debt market and uncollateralized credit markets. But price-based measures of debt market segmentation are inappropriate when solvency risk differs across countries: only the component of yield differentials that is not a reward for the issuer’s credit risk may reflect segmentation. We apply this idea to the euro sovereign debt market, using a dynamic factor model to decompose yield differentials in a country-specific and a common (or systemic) risk component. As the country-specific component dominates, purging yields from it produces much smaller measures of bond market segmentation than conventional ones for the crisis period. We also investigate how the home bias of banks’ sovereign portfolios – a quantity-based measure of segmentation – is related to yield differentials, by estimating a vector error-correction model on 2008-12 monthly data. We find that the sovereign exposures of banks in most euro-area countries respond positively to increases in yields, especially in periphery countries. When yield differentials are decomposed in their country-risk and common-risk components, we find that: (i) in the periphery, banks respond to increases in country risk by increasing their domestic exposure, while in core countries they do not; (ii) in contrast, in most euro-area countries banks respond to an increase in the common risk factor by raising their domestic exposures. Finding (i) hints at distorted incentives in periphery banks’ response to changes in their own sovereign’s risk. Finding (ii) indicates that, when systemic risk increases, all banks tend to increase the home bias of their portfolios, making the euro-area sovereign market more segmented.

JEL-codes: C32 C51 C58 G11 G15 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban and nep-opm
Date: 2013-04
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