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The eurozone crisis : how banks and sovereigns came to be joined at the hip

The eurozone crisis : how banks and sovereigns came to be joined at the hip. Ashoka Mody and Damiano Sandri Presented by Caterina Rho May 15, 2013. Outline. Introduction Financial crisis and sovereign default Theoretical Model Data and econometric approach Results

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The eurozone crisis : how banks and sovereigns came to be joined at the hip

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  1. The eurozone crisis:howbanks and sovereignscame to be joinedat the hip AshokaMody and Damiano Sandri Presented by Caterina Rho May 15, 2013

  2. Outline • Introduction • Financial crisis and sovereign default • Theoretical Model • Data and econometricapproach • Results • Comments • Conclusion

  3. Introduction • Empiricalanalysis of the link betweenfinancialcrisis and fiscal crisis in Eurozone in the period 2007-2011. • Reinhart and Rogoff (1999): twin crisis, the fiscal crisisfollows the financialcrisiswithoutbackwardeffect. • Thispaper: the public debtcrisis and the financialcrisismutuallyreinforce. • Twolevel of analysis: • General panel data analysis • Contrylevelanalysis • Beginning of Europeancrisis: nationalizaton of Anglo-Irish Bank.

  4. Timing of the crisis • July 2007: subprimecrisis. The risk premia on sovereign bonds in EZ countries rise homogenouslythrough EZ in line with global trends. • March 2008: rescue of Bear Stearns,beginning of a separate Europeancrisis. Sovereignspreadsstarted to respond to the weaknesses of theirownfinancialsectors. • January 2009, May 2010 : nationalization of Anglo-Irish bankand Greeksovereigncrisis.Sovereignweaknessesstarted to be transmitted to the financialsector. Potential for mutualdestabilization.

  5. Increase and dispersion of Eurozone sovereignspreads (bps)

  6. Theoretical model (1) • Twoperiod model • Agents: government, banks, private investors. • Period 1: the governmentissues a stock of bonds guaranteeing a rate of return , the exogenous risk-free rate. • Period 2: the governmentrepays the debtsubject to the budget constraint: • : the debt/GDP ratio can’texceed a default threshold. • with and country specific • : the level of capital investmentisdetermined by the financialsector.

  7. Theoretical model (2) • Government budget constraint: • Condition on sovereigninterest rate: • is country specific. • If a negative shock occurs, the debt/GDP ratio rises. • Ifrises, also the default probability and the spread will rise.

  8. Data and econometricapproach (1) • Data: • weeklychanges in spread of sovereign bonds • 10 countries in the Eurozone • From January 2006 to November 2011 • Elements of the analysis: • The sovereign spread : difference between the secondary market yield on the country 10-year bond and the yield on Germanbund • An high-frequencymeasure of financialsectorexpectations, :

  9. Expectations of the financialsector and the sovereignspreads

  10. Data and econometricapproach (2) Lags of spread Country f.e. LB dummy Lags of financial weaknessindex Controls

  11. Data and econometricapproach (3) • Analysis of the determinants of the changes in sovereignspreadsbefore and after Anglo-Irish bailout. • Granger-Causality test for reverse causality: • Test for country differences.

  12. Results • Pre-Angloperiod: • Until 2007: the changes in spreads are random. • 2007-Bear Stearns: changes due to global factors. • Bear Stearns-Anglo Irish: changes due to domesticfinancialmarkets. • Post-Angloperiod: • Contemporaneouscorrelationbetweenfinancial stress and rise in sovereignspreads. • Rising of eurozonerisk.

  13. Phase 1: changes in spreadsbefore Anglo Irish

  14. Phase 2: changes in spreadsafter Anglo-Irish

  15. Country differences by growthprospects

  16. Country differences by fiscal position

  17. Comments Alternative to Bear Stearns: Northern Rock, Greecebailout

  18. Conclusion • Empiricalstudy about how the financial component and the fiscal component are intertwined in the Eurozonecrisis. • Analysis of the relationshipbetweenfinancial stress and sovereignyieldspreads. • Simple explanation of a complexproblem • Too simple? Variousinterpretations of the timing and dynamics of the Europeancrisis. • Difficult to establishcausality

  19. References • Kaminsky, G. and C. Reinhart. 1999. “The Twin Crises: The Causes of Banking and Balance of Payments Problems.” American Economic Review 89: 473–500. • Kliesen, K. and D. C. Smith:“Measuring financial market stress” Economic Synopses, Federal Reserve Bank of St. Louis, 2, 2010 • Mody A. and D. Sandri: “The eurozone crisis: how banks and sovereigns came to be joined at the hip” Economic Policy, 27, 70: 199-230, April 2012

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