Banking soundness indicators and sovereign risk in time of crisis: the case of the European Union

Abstract

This paper examines the impact of the soundness of the banking sector on sovereign risk of EU member countries during the financial crisis by using a selection of financial soundness indicators (FSIs) and the sovereign ratings of the three main rating agencies. Unlike previous literature that typically focus on the ability of FSIs to foresee banking crises, we estimate ordered response models to assess the power of these indicators to explain sovereign risk. Our results show that evaluations made by the rating agencies are related to the lagged values of core FSIs such that an improvement in these indicators leads to improvements in upcoming sovereign ratings. Hence, reinforced banking soundness would reduce the sovereign risk. Accordingly, governments, supervisors and central banks should pay close attention to the evolution of certain FSIs related to the banking sector, in addition to other variables that have traditionally been taken into account in analyzing sovereign risk.