Sovereign risk, bank funding and investors’ pessimism

Abstract

Data show that sovereign risk reduces liquidity, increases funding cost and risk of banks highly exposed to it. I build a model that rationalizes this fact. Banks act as delegated monitors and invest in risky projects and in risky sovereign bonds. As investors hear rumors of increased sovereign risk, they run the bank (via global games). Banks could rollover liquidity in repo market using government bonds as collateral, but as sovereign risk raises collateral values shrink. Overall banks' liquidity falls (its cost increases) and so does banks' credit. In this context noisy news (announcements with signal extraction) of consolidation policies are recessionary in the short run, as they contribute to investors and banks pessimism, and mildly expansionary in the medium run. The banks liquidity channel plays a major role in the fiscal transmission.JEL classification: E5, G3, E6.

Sovereign Risk and the Bank Lending Channel: Differences across Countries and the Effects of the Financial Crisis

“…The previous channels, thus, all suggest that the deterioration of the financial conditions of banks caused by sovereign risk will reduce loan supply, 2 thereby 2. Several studies have shown that sovereign risk, by increasing the funding costs of banks, leads to a reduction in loan supply (Drago and Gallo 2016, Faia 2017, Grigorian and Manole 2017, Li and Zinna 2018.…”

Sovereign risk and asset market dynamics in the euro area

“…However, the models in this literature, do not focus on the specificity of the euro area, and do not consider the risk of default on sovereign bonds. DSGE models used to study the impact of sovereign default consider the pricing of debt (Juessen et al, 2016), the role of debt maturity , and the transmission of a sovereign default through the banking sector (van der Kwaak and van Wijnbergen, 2014;Bocola, 2016;Faia, 2017) in close economies. Very few papers analyze the impact of sovereign default at the euro area level, and those that do focus on explaining transmission through the banking sector (Guerrieri et al, 2012), or the stabilizing effect of monetary and fiscal policies Corsetti et al, 2014).…”

Fiscal Multipliers with Financial Fragmentation Risk and Interactions with Monetary Policy

“…Both channels lead banks to increase their lending rates, which adversely affects the real economy as households and firms face higher borrowing costs. Recent exposition of such models can be found for example in Bocola, Luigi (2016) and Ester Faia (2017). Note that the pressure on activity due to tighter borrowing conditions in turn leads to repricing of sovereign risk in models with endogenous fiscal limits, thereby completing the feedback loop.…”