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Zero Risk Contagion - Banks' Sovereign Exposure and Sovereign Risk Spillovers

This paper identifies banks' exposures to non-domestic sovereign debt as a transmission channel for sovereign risk spillovers in Europe. We construct a new measure - the 'sovereign subsidy' - that quantifies non-domestic sovereign exposures that are not adequately reflected in bank capital due to the application of zero risk weights. A larger sovereign subsidy for the banking sector amplifies the co-movement between its domestic sovereign's CDS spread and a European sovereign CDS market index. This result is robust to controlling for alternative spillover channels and a variety of other tests highlighting the importance to address sovereign risk in bank regulation.