Does the deterioration in the situation of public finances make banks more risky, or does the deterioration in the situation of banks make public debts more risky?

- "It is possible to have two interpretations of the relationship between sovereign risk and banking risk:

(1) If a country’s public finances deteriorate, the government will not be able to bail out the banks  especially major banks) since there will not be any budgetary resources to do so; the banking risk is therefore increased by the lack of a possibility of a bail out. This implies a causality heading from sovereign risk to banking risk.

(2) If a country’s banks struggle, investors believe that the government will have to bail them out; this increases the expected fiscal deficit. There is then a causality heading from banking risk towards sovereign risk."

- "To discriminate between these two hypotheses, we look at the causal links between sovereign CDS and bank CDS. We find that bank CDS are correlated, with a lag, to sovereign CDS in most cases: most often, sovereign risk causes the banking risk."

Natixis Special Report 179 20100908