As European governments scale up investment, bond market stability is more critical than ever. This column shows that financial fragmentation can undermine that stability by amplifying the sensitivity of both sovereign and corporate credit markets to global risk shocks. Crucially, this vulnerability affects jurisdictions across the euro area.
There is no generally accepted definition of financial fragmentation. In this column, we follow the Financial Stability Board (2019) and describe fragmentation as the breakdown of markets into fragments or segments, either geographically or by product type or participant. Fragmentation can undermine market efficiency, hinder the optimal allocation of resources and potentially affect economic growth and financial stability. In a single monetary union, the transmission of monetary policy can also be impaired.
Fragmentation can stem from many sources, including geopolitical factors, differences in legal and regulatory frameworks, market development, and investor bases. However, fragmentation can also be driven by self-perpetuating dynamics, as behavioural biases lead to persistent trading patterns. These effects make fragmentation difficult to explain using observable fundamental variables alone. We therefore treat financial fragmentation as a latent state variable - not directly observable, but its importance can be inferred by looking at market dynamics. In a recent paper (Mosk and de Vette 2025), we exploit this idea to construct a fragmentation indicator. Our focus is on the implications of financial fragmentation for financial stability rather than its underlying causes.
During the European sovereign debt crisis, markets focused often on sovereign spreads. Sovereign spread divergences driven by macroeconomic fundamentals or fiscal risks do not necessarily signal fragmentation, even in efficient and integrated markets. Therefore, we do not focus on the level of spreads or yields, but as discussed below, we examine their dynamics.
If spreads don't reliably signal fragmentation, how can we capture this latent variable? One approach is to consider market inefficiencies - such as persistent violations of arbitrage conditions - as a proxy for fragmentation. However, models aimed to estimate deviations from fair value are vulnerable to misspecification and omitted variables. Moreover, inefficiencies may stem from other sources, and they can be absent even when fragmentation does exist. Kakes and van den End (2023) tackle these challenges by modelling financial fragmentation via the higher moments of the sovereign spread distribution that cannot be accounted for by macro-financial fundamentals.
To track fragmentation, we construct an indicator based on how government bond yields move relative to one another. Our approach is based on the idea that similar assets should show price co-movement in response to common shocks. Conversely, if there is a correlation breakdown into segments, we interpret this as evidence of financial fragmentation. Our analysis of yield dynamics shows that the co-movement pattern is dominant (see Figure 1, left), but the second-most important pattern shows a breakdown of correlations into two blocks (see Figure 1, right). Our indicator measures the importance of such fragmented dynamics (see Figure 2). Details are given in Mosk and de Vette (2025).
Figure 1 Dominant patterns in euro area sovereign yield changes
(dimensionless components of the first and second principal components)
Before the Global Financial Crisis, the indicator was low (see Figure 2). It rose sharply during the sovereign debt crisis, with block divergences (see Figure 1, right) explaining almost 45% of yield dynamics, before gradually declining thereafter. As Buti (2020) notes, fragmentation risks never fully disappeared and could re-emerge in the face of shocks. Two further observations stand out. The indicator peaked around the Draghi's "whatever it takes" moment in 2012. The indicator peaks again in 2016, but subsequently declines, broadly coinciding with the expansion of ECB asset purchases. It declined further after the Pandemic Emergency Purchase Programme (PEPP) was launched, and only briefly flared up before the introduction of the Transmission Protection Instrument (TPI) in 2022. Overall, these patterns suggest that these ECB programmes have played a role in containing fragmentation (Zenios et al. 2022).
Figure 2 Euro area financial fragmentation indicator
(share of variance explained by divergent yield dynamics over a twelve-month moving window)
Market liquidity, especially under stress, is a key indicator of financial resilience. When liquidity dries up, even small trades can trigger sharp price moves. Figure 3 shows that for a given deterioration of German bond market liquidity (e.g. in times of stress), the deterioration for Italian bonds is much more severe when our fragmentation indicator is elevated. When the indicator is lower, the deterioration is comparable for Italian and German markets.
A similar observation can be made for redenomination risk - the possibility of a breakup of the euro area and a return to national currencies - which is commonly measured by quanto CDS spreads (De Santis 2015, 2019). These spreads are positively correlated with our fragmentation indicator when it is above its median value (see Figure 4). This suggests that the fragmentation indicator captures the euro area breakup risks as indicated by the quanto spreads.
Figure 3 Bond market liquidity in higher and lower fragmentation regimes
(Bloomberg illiquidity index points)
Figure 4 Break-up risk and euro area financial fragmentation
(basis points)
Financial fragmentation can weaken financial stability by increasing markets' sensitivity to shocks. In segmented markets, global risk shocks can trigger outsized price movements, especially in more vulnerable jurisdictions. Anaya Longaric et al. (2023) find that following a 'euro disaster risk' shock, investment funds shed 'peripheral' debt, which is largely absorbed by domestic banks in the short term; this raises concerns about vulnerabilities in the bank-sovereign nexus. In turn, banks' perceived sovereign dependence can lead to a fragmentation of interbank markets, according to Gabrieli and others (2018).
Rather than linking fragmentation directly to levels of risk, such as CDS spreads, we treat it as a latent system variable - one that shapes how markets respond to shocks. To assess this, we identify global risk shocks using a sign-restricted BVAR, following Brand et al. (2021), and then examine how credit risk premiums in euro area bond markets react to such shocks under different fragmentation regimes.
We find that both sovereign and corporate credit risk premia respond more strongly to common global risk shocks during periods of higher fragmentation (see Figure 5), whilst controlling for euro area macro and policy shocks. This heightened sensitivity is evident not only in vulnerable countries but also in the jurisdictions that are typically considered as more resilient, pointing to broader market fragility.
Figure 5 Credit spreads sensitivity to global risk shocks
(percentage change of credit risk premium)
The evidence presented in this column suggests that euro area financial fragmentation is linked to increased bond market fragility across jurisdictions - not just those traditionally considered more stable. Although our indicator correlates with liquidity conditions and redenomination risks, the root causes of fragmentation remain unexplored in our analysis. At the same time the association with heightened shock sensitivity implies that reducing fragmentation could enhance market resilience.
Deeper market integration could help mitigate fragmentation. However, it is important to distinguish between fragmentation and warranted risk differentiation. Sovereign spread divergences driven by fundamentals do not necessarily signal fragmentation.
Authors' note: This column is partially based on Mosk and Vette (2025) ©International Monetary Fund. The views expressed in this column are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. Views do also not necessarily reflect those of De Nederlandsche Bank.
Anaya Longaric, P, K Cera, G Georgiadis, and C Kaufmann (2025), "Investment Funds and Euro Disaster Risk", VoxEU.org, 6 July.
Brandt, L, A Saint Guilhem, M Schröder, and I Van Robays (2021), "What Drives Euro Area Financial Market Developments? The Role of US Spillovers and Global Risk", ECB Working Paper No. 2560.
Buti, M (2020), "A Tale of Two Crises: Lessons from the Financial Crisis to Prevent the Great Fragmentation", VoxEU.org, 13 July.
Claessens, S (2019), "Fragmentation in Global Financial Markets: Good or Bad for Financial Stability?", Bank for International Settlements Working Paper No 815.
Gabrieli, S and C Labonne (2018), "Euro Area Interbank Market Fragmentation: New Evidence on the Roles of Bad Banks Versus Bad Sovereigns", VoxEU.org, 2 November.
Kakes, J P and J Willem Van den End (2023), "Identifying financial fragmentation: do sovereign spreads in the EMU reflect differences in fundamentals?", De Nederlandsche Bank Working Paper No. 792.
Mosk, B and N de Vette (2025), "Euro Area Financial Fragmentation and Bond Market Stability", International Monetary Fund Working Paper Issue 125/94.
Zenios, S, G Cheng, A Consiglio and E Alberola (2022), "The ECB's asset purchase programme granted debt sustainability in the pandemic. Its termination should not derail it," VoxEU.org, 24 September.