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Abstract

This paper investigates the role of banks’ foreign asset holdings in transmitting credit risk internationally. Foreign exposure in risky assets might severely affect the solvability of credit institutions. Credit risk, in turn, transfers from banks to public accounts as a consequence of implicit or explicit bailout guarantees to distressed banking systems. This paper articulates this mechanism with a simple model where governments choose to fill banks' capital gaps to self-protect from the severe economic consequence of a banking sector default. Referring to the existing literature on the determinants of sovereign yield spreads in the second part of the paper, I present empirical evidence of the link between banks’ foreign claims and countries' credit risk. Results for the eurozone identify banks' foreign exposure as a major determinant of sovereign default probability. Also, governments' vulnerability to credit risk spill over decreases with banks' capitalisation and sovereigns' fiscal soundness.

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