Do institutions prevent contagion in financial markets? Evidence from the European debt crisis

ABSTRACT

The recent European Sovereign Debt Crisis brought in attention a number of structural problems in the European Union. Part of the effort to correct these problems in the countries that were mostly affected by the crisis were a number of policy responses from the European Union, the European Central Bank, the International Monetary Fund and the Local Governments. In this study, we attempt to assess the success of these responses to constrain the contagion of the crisis from the banking sector to the real economy sectors of the Eurozone countries. Our results show that policy announcements from the EU/ECB/IMF affect the transmission of shocks generated in the banking sector to the market. Moreover, policy responses of the national governments also seem to play a role in the contagion of the crisis.

KEYWORDS:

• Contagion
• financial risk
• policy announcements

JEL CLASSIFICATIONS:

• M41
• F30
• G01
• G15

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1 By the term medium volatility, we refer to periods with conditional volatility in the banking sector that is higher than the 95% threshold, while by the term high volatility we refer to periods with conditional volatility in the banking sector that is higher than the 99% threshold. See the Appendix at the end of the paper for a more detailed definition.

2 Granger (1988) points out that a significant error correction term signifies the existence of long-run causality. On the other hand, the significant coefficient on the change of the banking index shows causality in the short run.