From Bear Stearns to Anglo Irish: How Eurozone Sovereign Spreads Related to Financial Sector Vulnerability

IMF Working Papers, May 1, 2009

Source details

Canonical URL: From Bear Stearns to Anglo Irish: How Eurozone Sovereign Spreads Related to Financial Sector Vulnerability

Following the onset of the subprime crisis in July 2007, sovereign spreads across the eurozone rose, but the rise was mainly on account of common global factors.
The rescue of Bear Stearns in March 2008 marked a turning point: countries thereafter became increasingly differentiated in their sovereign spreads.
Sovereign spreads of a eurozone country tended to rise when the prospects of its domestic financial sector worsened.
The evidence suggests the rescue of Bear Stearns created a link between financial sector vulnerabilities and a larger contingent liability on public finances.
After the failure of Lehman Brothers, spreads also rose faster for countries with higher ratios of public debt-to-GDP.
The transitional dynamics appear to have concluded with the nationalization of Anglo Irish: sovereign spreads throughout the eurozone jumped, with that jump emphasizing differentiation by financial sector vulnerability and public debt levels.
The results imply that, to varying degrees, countries may have moved to a new regime characterized by:
- weak economic outlook,
- financial sector fragilities,
- and strains on public finances.

Timeline of structural shifts:
- July 2007: Subprime crisis onset — common global factors dominate spread increases.
- March 2008: Bear Stearns rescue — emergence of cross-country differentiation linked to domestic financial sector prospects.
- Post-Lehman Brothers failure: Faster spread increases in countries with higher public debt-to-GDP ratios.
- Nationalization of Anglo Irish: System-wide jump in spreads reinforcing the role of financial-sector vulnerability and public debt in differentiating sovereign risk.
Mechanism proposed:
- Rescue operations and high-profile failures altered market perceptions of contingent fiscal liabilities arising from financial sector distress, thereby connecting bank fragility to sovereign risk premia.

Monitoring and mitigating financial sector vulnerabilities is crucial for sovereign risk management because financial distress can translate into contingent fiscal liabilities that widen sovereign spreads.
Public debt positions matter more under stress: higher public debt-to-GDP ratios can amplify sovereign spread responses after major financial shocks.
The sequence of events highlights the importance of crisis prevention and resolution frameworks that limit the degree to which financial-sector interventions create or signal large contingent liabilities for sovereigns.