Bank risk behavior and connectedness in EMU countries

•We estimate the banking sector risk behavior in EMU over the period 2004-Q4 to 2013-Q2.•We compute average “Distance-to-default (DtD)” for a representative set of banks at country level.•Average DtD is strongly correlated with market sentiments and outperform regulatory risk measures.•GC test reveals no systemic component, and Diebold–Yilmaz index suggests low connectedness.•Results suggest more cautious requirement in modeling a priori dependence among bank. Given the structural differences in banking sector and financial regulation at country level in European Economic and Monetary Union (EMU), this paper tries to estimate the banking sector risk behavior at country level. Based on contingent claim literature, it computes “Distance-to-default (DtD)” at bank level and analyzes the aggregate series at country level for a representative set of banks over the period 2004-Q4 to 2013-Q2. The indices provide an intuitive, forward-looking and timely risk measure having strong correlations with national/regional market sentiment indicators. An underlying trend exists, but causality tests suggest no systemic component. Cross-sectional differences in DtD suggests fragility in EMU countries 12–18 months prior to the crisis and better predictive ability than the regulatory index based on large and complex banking institutions at European level. Furthermore, we explore the reasons for this divergence using VAR estimates.