Measuring Credit Risk in the Euro Area

...credit spread indexes are strong predictors of future economic activity and of the growth in bank lending.

Measuring the extent of financial distress for countries within the European financial system is a difficult challenge. In Credit Risk in the Euro Area (NBER Working Paper No. 20041), Simon Gilchrist and Benoît Mojon develop new indexes of credit risks in the euro area. They analyze information on hundreds of thousands of monthly observations on the yield to maturity of corporate bonds since the launch of the euro in January 1999, and define the credit spread at the bond level as the difference between the corporate bond yield and the yield of a same-maturity German Bund zero coupon bond. They aggregate these bond-level credit spreads to obtain indexes of credit risk for both banks and non-financial corporations in Germany, France, Italy, and Spain, as well as for the entire euro area. The authors find that the financial crisis of 2008 dramatically increased the cost of market funding for both financial and non-financial firms in the euro area. In addition, coincident with the rise in sovereign default risk in the euro system, they find increasing fragmentation of the European financial system along national lines since 2010.

They also determine that their credit spread indexes are strong predictors of future economic activity and of the growth in bank lending. They are predictive of industrial production, unemployment, and real GDP both at the country level and for the entire euro area. These findings underscore the real consequences of deterioration in financial conditions.

-- Matt Nesvisky