This paper investigates the interaction of market views on the sustainability of sovereign debt and the perceived credit risk of banks. This interaction came into spotlight during the recent financial crisis, as government interventions in support of the financial sector were associated with increases in fiscal burden. I analyze and quantify the effect of government interventions in the domestic financial system on the default risks of the banking sector and sovereign borrowers. The paper focuses on the cases of Ireland and Spain, which experienced large public interventions in the domestic banking system and at a later stage highly volatile bond markets. For each country, I estimate a Vector Autoregression model to trace the interaction among sovereign CDS spreads, bank CDS spreads, and a measure of the business cycle over the sample period 2007-2011. I identify shocks by imposing sign restrictions on the impulse response functions. The results point towards a risk transfer from the financial to the sovereign sector, which generates an increase in the credit risk of the latter but only a temporary drop in that of banks.
Keywords: Financial Crises, Sovereign Debt, VAR, Sign Restrictions.
JEL Classification: C32, E44, H63.