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Sovereign risk, interbank freezes, and aggregate fluctuations

Philipp Engler and Christoph Grosse Steffen

No 1840, Working Paper Series from European Central Bank

Abstract: This paper studies the bank-sovereign link in a dynamic stochastic general equilibrium set-up with strategic default on public debt. Heterogeneous banks give rise to an interbank market where government bonds are used as collateral. A default penalty arises from a breakdown of interbank intermediation that induces a credit crunch. Government borrowing under limited commitment is costly ex ante as bank funding conditions tighten when the quality of collateral drops. This lowers the penalty from an interbank freeze and feeds back into default risk. The arising amplification mechanism propagates aggregate shocks to the macro-economy. The model is calibrated using Spanish data and is capable of reproducing key business cycle statistics alongside stylized facts during the European sovereign debt crisis. JEL Classification: E43, E44, F34, H63

Keywords: Bank-sovereign link; Domestic debt; interbank market; Non-Ricardian effects; Occasionally binding constraint; secondary markets; sovereign default (search for similar items in EconPapers)
Date: 2015-08
New Economics Papers: this item is included in nep-ban, nep-dge and nep-mac
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Related works:
Journal Article: Sovereign risk, interbank freezes, and aggregate fluctuations (2016) 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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Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20151840

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