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Sovereign risk, interbank freezes, and aggregate fluctuations

Philipp Engler and Christoph Grosse Steffen

European Economic Review, 2016, vol. 87, issue C, 34-61

Abstract: This paper shows how spillovers from sovereign risk to banks׳ access to wholesale funding establish a bank-sovereign nexus. In a dynamic stochastic general equilibrium set-up, heterogeneous banks give rise to an interbank market where government bonds are used as collateral. Government borrowing under limited commitment is costly ex ante as bank funding conditions tighten when the quality of collateral drops. These spillovers, by impeding interbank intermediation, lower the penalty from defaulting due to an interbank freeze during a recession and propagate aggregate shocks to the macroeconomy. The model is calibrated using Greek data and is capable of reproducing stylized facts from the European sovereign debt crisis. In an application, we show that the ECB׳s non-standard financing operations mitigate the adverse feedback mechanism.

Keywords: Sovereign default; Bank-sovereign link; Interbank market; Domestic debt; Credit policies (search for similar items in EconPapers)
JEL-codes: E43 E44 F34 H63 (search for similar items in EconPapers)
Date: 2016
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Working Paper: Sovereign risk, interbank freezes, and aggregate fluctuations (2015) Downloads
Working Paper: Sovereign Risk, Interbank Freezes, and Aggregate Fluctuations (2014) Downloads
Working Paper: Sovereign risk, interbank freezes, and aggregate fluctuations (2014) Downloads
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DOI: 10.1016/j.euroecorev.2016.02.012

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