On the importance of indirect banking vulnerabilities in the Eurozone

Abstract

This paper investigates banking and sovereign distress in the Eurozone and the importance of direct and indirect financial exposures. We use BIS cross-border banking claims to link member states in a GVAR framework and jointly model sectoral CDS premia. Based on balance sheet positions of an intermediate debtor country, we calculate indirect exposures and asses how the level of interconnectedness is impacted when indirect links are accounted for. We notice a general slowdown in financial integration and a reduction in cross-border assets in the hope of limiting international contagion. By differentiating between direct and indirect links, we show that the impact of reduced weights on core member states is mostly insignificant and that deleveraging strategies are not generally able to successfully reduce risk.