The Impact of Sovereign and Credit Risk on Interest Rate Convergence in the Euro Area

36 Pages Posted: 3 Jun 2014 Last revised: 30 Jun 2014

See all articles by Ivo J.M. Arnold

Ivo J.M. Arnold

Nyenrode University; Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE)

Saskia E. van Ewijk

De Nederlandsche Bank; Nyenrode Business University

Date Written: June 3, 2014

Abstract

This paper employs a time-varying parameter state space model to explore the impact of the crisis on bank retail rates in the euro area. We show that σ-convergence in interest rates has been adversely affected by the crisis and quantify the role of sovereign and credit risk as two alternative explanations for the increase in financial fragmentation. A key finding is that the heterogeneity in sovereign risk across member states accounts for a sizable part of the increase in the cross-sectional dispersion of various lending and deposit rates. In contrast, the impact of the increased heterogeneity in credit risk on bank retail rates is negligible. Our results suggest that efforts to reduce sovereign tensions -- as exemplified by the ECB’s OMT program -- may help to reduce financial fragmentation.

Keywords: bank retail rates, σ-convergence, sovereign risk, credit risk, state space model

JEL Classification: E43, G21, H63

Suggested Citation

Arnold, Ivo J.M. and van Ewijk, Saskia E., The Impact of Sovereign and Credit Risk on Interest Rate Convergence in the Euro Area (June 3, 2014). De Nederlandsche Bank Working Paper No. 425, Available at SSRN: https://ssrn.com/abstract=2445322 or http://dx.doi.org/10.2139/ssrn.2445322

Ivo J.M. Arnold (Contact Author)

Nyenrode University ( email )

3621 BG Breukelen
Netherlands
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Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
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Saskia E. van Ewijk

De Nederlandsche Bank ( email )

PO Box 98
1000 AB Amsterdam
Amsterdam, 1000 AB
Netherlands

Nyenrode Business University ( email )

Straatweg 25
P.O. Box 130
Breukelen, 3620 AC
Netherlands

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