This paper aims to analyze influencing factors on the covariation between sovereign and bank sector credit risks – the so-called sovereign–bank nexus.
Risk transmissions between sovereigns and banks are measured via credit default swap spreads with sovereign bond portfolios as well as capital ratios of large European banks between 2011 and 2020 serving as moderator variables in moderated multiple regression analyses.
The authors find a state dependent effect of exposure size: for low-risk sovereigns, higher bank exposures to the domestic sovereign strengthen the nexus. For high-risk sovereigns, higher exposures weaken the nexus. They attribute these findings to a state-dependent dominance of the underlying risk transmission channels – the asset channel and liquidity channel in the low-risk state, and the economy channel in the high-risk state. Furthermore, they confirm that, consistent with a guarantee channel and a bailout channel, the nexus weakens with the financial strength of banks. However, this effect reverses for the lowest decile of very weakly capitalized banks.
While this paper does not aim to derive prescriptive regulatory recommendations, the findings offer several insights that may be informative for bank regulation and supervisory practice. A central implication of our results is that the sovereign–bank nexus cannot be adequately assessed using one-size-fits-all approaches. The impact of sovereign exposures on financial stability depends critically on the sovereign risk environment and bank characteristics. Regulatory measures that treat domestic sovereign exposures as uniformly destabilizing may therefore overlook important stabilizing channels in high-risk environments.
The results underscore the importance of incorporating state dependence and interaction effects into supervisory stress tests and risk assessments. Evaluations of sovereign risk exposures may benefit from jointly considering exposure size, sovereign risk and bank strength, rather than focusing on aggregate measures in isolation. From this perspective, policies aimed at improving transparency and risk-sensitive monitoring of sovereign exposures may be more effective than approaches to constrain exposure levels.
The findings suggest that strengthening the resilience of the banking sector – rather than mechanically breaking the sovereign–bank nexus – remains a key objective for regulation and supervision.
The paper provides a conceptual re-assessment of the sovereign–bank nexus by showing that its strength and direction depend on the interaction of exposure size, sovereign risk and bank financial strength. By decomposing aggregate sovereign exposure measures and identifying competing transmission channels, the authors demonstrate that the nexus is a state dependent and nonlinear phenomenon rather than a uniform risk amplification mechanism.
