The interplay of sovereign spreads and banks’ fragility in the Eurozone

by Ashoka Mody and Damiano Sandri

Vox
November 23, 2011

European policymakers are confronting a heightened crisis characterised by a perverse and seemingly intractable interplay between sovereign debt pressures and financial-sector fragilities. This column argues that the payoffs from strengthening banks’ balance-sheets can still be large and, therefore, fiscal support is merited. But a more resolute strategy for winding down banks is also needed.

European policymakers are confronting a heightened crisis characterised by a perverse and seemingly intractable interplay between sovereign debt pressures and financial-sector fragilities (Wolff 2011). Three questions arise:

• How did the crisis reach this stage?
• How should we think of policy options when the financial sector and sovereign weaknesses threaten to pull each other down?
• What policy interventions have the best chance to succeed at this time?

To shed light on these questions, we analyse the correlation structure between weekly changes in sovereign spreads and banks’ equity valuations in a panel of Eurozone countries (Mody and Sandri 2011).

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