The failure of one economic entity can trigger cascading effects, endangering the broader financial system. The regulator’s decision to allow European banks to assign a 0% risk to sovereign bonds from any European Union countries might inadvertently lead banks to hold riskier debts, thereby increasing the potential for sovereign risk.

This thesis investigates the relationship between banks and sovereign governments, emphasizing European systemic banks and their sovereign debt holdings in Greece, Ireland, Italy, Portugal, and Spain. With partial correlations and generalized impulse response functions via a vector autoregressive model, this thesis sheds light on this relationship’s intricacies during and post the European sovereign debt crisis. The study incorporates data on bank sovereign exposures and reviews relevant regulations to offer a holistic perspective.

Key findings indicate persisting sovereign debt exposure to Greece, Ireland, Italy, Portugal, and Spain in many European systemic banks. Notably, heightened exposures of UniCredit and Santander suggest sovereign risks tied to potential instabilities in Italy and Spain. Moreover, the (rolling) partial correlation analyses affirmed that heightened sovereign exposure mostly amplifies financial interdependencies. Generalized impulse response functions, utilized in assessing financial shock transmission, indicated reduced shock transmission post-European debt crisis. However, a persistent home bias was consistently observed. Additionally, Debt-to-GDP ratios for several peripheral countries have escalated since 2010, underlining potential domino effects due to the interconnectedness of financial institutions. Conclusively, the research emphasizes that despite the post-crisis measures, sovereign risk remains a dominant concern for European systemic banks. The findings spotlight potential weaknesses in the European banking infrastructure and advocate for a comprehensive understanding of bank-state dynamics to fashion effective reformative measures.