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Spain’s risk premium and Financial Vulnerability

Spain’s risk premium and Financial Vulnerability

A topic that has recently received considerable attention is the link between country spreads and financial fragility. Generally speaking, financial sector vulnerabilities have been shown to be strongly associated with higher risk premiums. The basic logic is that financial sector stress projects a deterioration of growth prospects. In turn, the weaker economic outlook increases default probabilities; thereby exerting further pressure on the financial industry, and hence increasing risk country premiums. Put it differently, the health of the financial sector, economic activity and country premiums tend to be self-reinforcing forces.

To obtain a historical sense for how Spain’s country spread relates to financial vulnerability, the Figure plots Spain’s risk premium and the bank capital to loans ratio of Spanish banks and credit finance establishments from 1980 to 2015. The Figure shows a clear inverse relationship between both magnitudes. The cross-correlation is indeed -0.34. In words, financial fragility seemed to be associated with wider sovereign spreads.

All told, country spreads are broadly viewed as a comprehensive indicator of a country’s overall risk premium, arising from market, credit, liquidity, and other risks.

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