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Sovereign Risk and Bank Risk-Taking

Anil Ari

Cambridge Working Papers in Economics from Faculty of Economics, University of Cambridge

Abstract: In European countries recently hit by a sovereign debt crisis, banks have sharply raised their holdings of domestic sovereign debt, reduced credit to forms, and faced rising financing costs, raising concerns about economic and financial resilience. This paper develops a general equilibrium model with optimizing banks and depositors to account for these facts and provide a framework for policy assessment. Under-capitalized banks in default-risky countries have an incentive to gamble on domestic sovereign bonds. Unless there is perfect transparency of bank balance sheets, the optimal reaction by depositors to bank insolvency risk leaves the economy susceptible to self-fulfilling shifts in sentiments. In a bad equilibrium, sovereign risk shocks lead to a prolonged period of financial fragility and a persistent drop in output. The model is quantified using Portuguese data and generates similar dynamics to those observed in the Portuguese economy during the debt crisis. Policy interventions face a trade-off between alleviating funding constraints and strengthening incentives to gamble. Liquidity provision to banks may eliminate the good equilibrium when not targeted. Targeted interventions have the capacity to eliminate adverse equilibria.

Keywords: Sovereign Debt Crises; Bank Risk-Taking; Financial Constraints (search for similar items in EconPapers)
JEL-codes: E44 E58 F34 G21 H63 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge, nep-eec and nep-mac
Date: 2016-11-17
Note: aa531
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http://www.econ.cam.ac.uk/research-files/repec/cam/pdf/cwpe1665.pdf

Related works:
Working Paper: Sovereign risk and bank risk-taking (2018) Downloads
Working Paper: Sovereign Risk and Bank Risk-Taking (2017) Downloads
Working Paper: Sovereign risk and bank risk-taking (2016) Downloads
Working Paper: Sovereign Risk and Bank Risk-Taking (2016) Downloads
Working Paper: Sovereign Risk and Bank Risk-Taking (2016) Downloads
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