Sovereign and Bank CDS Spreads During the European Debt Crisis: Laying the Foundation for SMEs’ Financial Distress

The paper nvestigate the causal relation between sovereign and bank credit risk in order to understand whether increases in sovereign risk (measured via sovereign CDS spreads) have an impact on the market perception of bank credit risk (measured via banks’ CDS quotes). The contagion effect between stressed sovereigns and the banking industry may be due to the exposure of domestic banks to their own country’s public debt. Based on daily quotes from 24 banks, pertaining to 7 euro-zone countries, for the period between 1 January 2010 and 27 May 2014, the chapter provides empirical evidence that sovereign CDSs have played a relevant role during the sovereign debt crisis in Europe, that is, the market perception about a country’s credit risk significantly affected the evolution of banks’ CDSs. These findings support the view that distressed banks, in response to the developments in sovereign debt turmoil, reduce lending to the private sector and increase the cost of funding for enterprises. This, in turn, penalises especially the SMEs, which, as often shown in the literature, heavily rely on bank financing.