European banks are exposed to a substantial amount of risky sovereign debt. The “missing bank capital” resulting from the zero risk weight exemption for European banks for European sovereign debt amplifies the co-movement between sovereign CDS spreads and facilitates cross-border financial-crisis spillovers. Risks spill over from risky periphery sovereigns to safer core countries, but not in the opposite direction nor for exposures to countries not exempted from risk-weighting. More bank capital as well as positive risk-weighting for sovereign exposures mitigates spillovers. Our results are robust to alternative hypotheses such as common shocks due to financial linkages among European countries, direct sovereign-sovereign spillovers, and the exposure of European banks to non-sovereign sectors.


sovereign debt, sovereign risk, spillovers, bank risk, CDS, zero risk weight exemption