The Impact of Sovereign Shocks

We investigate the interrelationships between macro-systems of governments and financial institutions by studying the dynamic propagation mechanisms of macroeconomic shocks. We propose a novel approach to identify relevant systemic shocks, and to classify them into sovereign or banking categories. Our econometric framework quantifies the impact and spillover rates of systemic shocks within and across both systems. We find that sovereign shocks have a significant and persistent impact on the probability of a collective banking default, but not vice versa. Finally, we explore sources of systemic fragility, potential mechanisms of shock transmission, and their implications for the real economy.