FV-84 | Systemic Risk Dynamics in Euro Area Sovereign Debt Markets

Before the Draghi Speech (whatever it takes)

Before the Draghi Speech (whatever it takes)

After the Draghi Speech

After the Draghi Speech

Prof. H. Zimmermann, Dr. K. Ters

Finanzmarkttheorie

Research Topic 
The recent global financial market crisis and the subsequent sovereign debt crisis in the euro-zone has led the ECB to introduce unconventional monetary policy measures with the aim to restore liquidity in the interbank and bond market. Several programmes aimed to improve creditworthiness of banks and sovereign entities and together with new regulatory frameworks tried to decrease systemic risk also arising from contagion (predominantly from Greece). Our research aims to analyse the effects of the ECB’s conventional and unconventional monetary policy as well as regulatory effects on the dynamics of systemic risk and contagion in the euro-zone from the perspective of sovereign entities. Understanding the effects of unconventional policy measures is important because it is very likely that they will become more prevalent in the future. In a low interest rate environment, central banks are constrained by the effective lower bound on nominal interest rates more frequently, making unconventional policies necessary such as outright buying of securities in the secondary market (e.g. quantitative easing, securities market programme). 

Statement of the Problem 
In this project, we will employ a network model based on the methodology of a VAR Variance decomposition based on Diebold and Yilmaz (2014) in order to understand the dynamics of sovereign risk interconnectedness. Macroprudential regulation views systemic risk as dependent on collective behaviour (endogenous), therefore, a network methodology is essential. We will investigate the magnitude and dynamics within the network before the unconventional policy or regulatory measure (called “events”) and compare it with the dynamics estimated in a short time window after the measure was adapted. We are able to work with very short time windows around an event, as we operate with intraday data for bond markets and CDS markets. Also, having data for credit risk from both, the cash and derivative market, enables us to identify which market was leading in the contagion (systemic risk spillover) within the network. E.g. was the risk transmission taking place through the bond market or the derivative market from one country to another? This is particularly important from a regulatory viewpoint. Even though the bond and the CDS markets have been both blamed for overreactions and contagion dynamics (e.g. the introduction of the ban on outright CDS shorting and fire sales in Italian and Spanish bonds following the Moody’s downgrade on 5 July 2011), quantifying evidence is still missing on which market has been the primary source for the transmission of sovereign risk contagion. Our results are crucial for policy makers and regulators to understand the dynamics in the market for sovereign credit risk, especially in the derivative market, where we find contagion dynamics to be more severe during our analysed crisis sample. Our dataset will comprise seven sovereign entities, consisting of the GIIPS countries (Greece, Ireland, Italy, Portugal and Spain) plus France as a control country and Germany as a near risk free country. No existing research paper (to the authors’ best knowledge) has so far investigated the role of the bond and the CDS market in the transmission of sovereign risk contagion. 

Suggestions of events are: 
1st Greece Economic Adjustment Programme (EAP): 28.04.2010 11:00 am
Securities Market Programme (SMP) 1st wave: 10.05.2010 08:30 am
Ireland EAP: 01.12.2010 08:30 am
Portugal EAP: 04.05.2011 08:30 am
Draghi speech “whatever it takes”: 26.07.2012 02:00 pm and many more still to be collected (estimated to be 50-60 in total). 

Objectives 
We will employ network models in order to estimate contagion and risk transmission among sovereign entities. We have conducted very preliminary feasibility test and expect as outcome a network before the event (regulatory or unconventional monetary policy effect) and one after the event. As a (very preliminary!) example.

The – very preliminary – results look already promising. In the CDS market, we see that in a 5-day window prior to the speech, contagion effects are heavily present between Italy, Spain and France and between France and Germany. After the speech, the risk dynamics altered as we only find contagion dynamics between Italy and Spain. Thus, the network after the event (Draghi speech) seems more stable, e.g. less vulnerable for credit risk contagion. The thicker the arrow the “heavier” is the interconnectedness between sovereign entities. Thus, the thickest arrow represents contagion or even systematic risk. The thickness of each arrow marks the size of the risk spillover (contagion) dynamics from one country to another country in the network according to the following scale: Wide, black arrows correspond to values greater or equal to the 3. Quartile of partial correlation; medium, darkgray arrows mark values between the median and third quartile, and thin, lightgray arrows mark small difference between the first quartile and median. 

Importance, Usefulness, and Novelty of the Project 
Integrated in Point 2./3./4.