Policy uncertainty, interest rate environment and the dynamic correlation between sovereign and bank default risk

This study assesses the impact of policy uncertainty and the interest rate environment on the sovereign-bank nexus considering 48 banks in 14 countries. By applying principal component analysis to bank CDS premia in a country, the dynamic conditional correlation between sovereign CDS premia and the common variation underlying bank CDS is specified. Fixed effects panel regression analysis shows that the sovereign-bank correlation significantly increases in times of great policy uncertainty, low bank interest margins, high interbank market rates, and a low ratio of bank Tier 1 capital. (C) 2021 Elsevier B.V. All rights reserved.