1. The eurozone crisis: how banks and sovereigns came to be joined at the hip Ashoka Mody and Damiano Sandri Presented by Caterina Rho May 15, 2013

2. Outline Introduction ▫Financial crisis and sovereign default Theoretical Model Data and econometric approach Results Comments Conclusion

3. Introduction Empirical analysis of the link between financial crisis and fiscal crisis in Eurozone in the period 2007-2011. Reinhart and Rogoff (1999): twin crisis, the fiscal crisis follows the financial crisis without backward effect.  This paper: the public debt crisis and the financial crisis mutually reinforce. Two level of analysis: ▫General panel data analysis ▫Contry level analysis Beginning of European crisis: nationalizaton of Anglo-Irish Bank.

4. Timing of the crisis July 2007: subprime crisis. The risk premia on sovereign bonds in EZ countries rise homogenously through EZ in line with global trends. March 2008: rescue of Bear Stearns, beginning of a separate European crisis. Sovereign spreads started to respond to the weaknesses of their own financial sectors. January 2009, May 2010 : nationalization of Anglo- Irish bank and Greek sovereign crisis. Sovereign weaknesses started to be transmitted to the financial sector. Potential for mutual destabilization.

5. Increase and dispersion of Eurozone sovereign spreads (bps)

6. Theoretical model (1)

7. Theoretical model (2)

8. Data and econometric approach (1)

9. Expectations of the financial sector and the sovereign spreads

10. Data and econometric approach (2) Lags of spread Lags of financial weakness index Controls Country f.e. LB dummy

11. Data and econometric approach (3)

12. Results Pre-Anglo period: ▫Until 2007: the changes in spreads are random. ▫2007-Bear Stearns: changes due to global factors. ▫Bear Stearns-Anglo Irish: changes due to domestic financial markets. Post-Anglo period: ▫Contemporaneous correlation between financial stress and rise in sovereign spreads. ▫Rising of eurozone risk.

13. Phase 1: changes in spreads before Anglo Irish

14. Phase 2: changes in spreads after Anglo-Irish

15. Country differences by growth prospects

16. Country differences by fiscal position

17. Comments Alternative to Bear Stearns: Northern Rock, Greece bailout

18. Conclusion Empirical study about how the financial component and the fiscal component are intertwined in the Eurozone crisis. Analysis of the relationship between financial stress and sovereign yield spreads. Simple explanation of a complex problem ▫Too simple? Various interpretations of the timing and dynamics of the European crisis. ▫Difficult to establish causality

19. References Kaminsky, G. and C. Reinhart. 1999. “The Twin Crises: The Causes of Banking and Balance of Payments Problems.” American Economic Review 89: 473–500. Kliesen, K. and D. C. Smith: “Measuring financial market stress” Economic Synopses, Federal Reserve Bank of St. Louis, 2, 2010 Mody A. and D. Sandri: “The eurozone crisis: how banks and sovereigns came to be joined at the hip” Economic Policy, 27, 70: 199-230, April 2012