IDEAS home Printed from https://ideas.repec.org/p/red/sed016/676.html
   My bibliography  Save this paper

Sovereign Risk and Bank Risk-Taking

Author

Listed:
  • Anil Ari

    (University of Cambridge)

Abstract

In European countries recently hit by a sovereign debt crisis, the share of domestic sovereign debt held by the national banking system has sharply increased, raising issues in their economic and financial resilience, as well as in policy design. This paper examines these issues by analyzing the banking equilibrium in a model with optimizing banks and depositors. To the extent that sovereign default causes bank losses also independently of their holding of domestic government bonds, undercapitalized banks have an incentive to gamble on these bonds. The optimal reaction by depositors to insolvency risk imposes discipline, but also leaves the economy susceptible to self-fulfilling shifts in sentiments, where sovereign default also causes a banking crisis. Policy interventions face a trade-off between alleviating funding constraints and strengthening incentives to gamble. Subsidized loans to banks, similar to the ECB's non-targeted longer-term refinancing operations (LTRO), may eliminate the good equilibrium when the banking sector is undercapitalized. Targeted interventions have the capacity to eliminate adverse equilibria.

Suggested Citation

  • Anil Ari, 2016. "Sovereign Risk and Bank Risk-Taking," 2016 Meeting Papers 676, Society for Economic Dynamics.
    • Handle: RePEc:red:sed016:676
    as

    Download full text from publisher

    File URL: https://red-files-public.s3.amazonaws.com/meetpapers/2016/paper_676.pdf
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Patrick Bolton & Olivier Jeanne, 2011. "Sovereign Default Risk and Bank Fragility in Financially Integrated Economies," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 59(2), pages 162-194, June.
    2. Yeyati, Eduardo Levy & Panizza, Ugo, 2011. "The elusive costs of sovereign defaults," Journal of Development Economics, Elsevier, vol. 94(1), pages 95-105, January.
    3. Uhlig Harald, 2014. "Sovereign Default Risk and Banks in a Monetary Union," German Economic Review, De Gruyter, vol. 15(1), pages 23-41, February.
    4. Carlo Altavilla & Marco Pagano & Saverio Simonelli, 2017. "Bank Exposures and Sovereign Stress Transmission," Review of Finance, European Finance Association, vol. 21(6), pages 2103-2139.
    5. Eduardo Borensztein & Ugo Panizza, 2009. "The Costs of Sovereign Default," IMF Staff Papers, Palgrave Macmillan, vol. 56(4), pages 683-741, November.
    6. Mark Aguiar & Manuel Amador & Emmanuel Farhi & Gita Gopinath, 2015. "Coordination and Crisis in Monetary Unions," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 130(4), pages 1727-1779.
    7. Benjamin Hébert & Jesse Schreger, 2017. "The Costs of Sovereign Default: Evidence from Argentina," American Economic Review, American Economic Association, vol. 107(10), pages 3119-3145, October.
    8. Bahaj, Saleem A., 2014. "Systemic sovereign risk: macroeconomic implications in the euro area," LSE Research Online Documents on Economics 58110, London School of Economics and Political Science, LSE Library.
    9. Nicola Gennaioli & Alberto Martin & Stefano Rossi, 2014. "Sovereign Default, Domestic Banks, and Financial Institutions," Journal of Finance, American Finance Association, vol. 69(2), pages 819-866, April.
    10. Crosignani, Matteo & Faria-e-Castro, Miguel & Fonseca, Luís, 2020. "The (Unintended?) consequences of the largest liquidity injection ever," Journal of Monetary Economics, Elsevier, vol. 112(C), pages 97-112.
    11. Diego J. Perez, 2015. "Sovereign Debt, Domestic Banks and the Provision of Public Liquidity," Discussion Papers 15-016, Stanford Institute for Economic Policy Research.
    12. Emmanuel Farhi & Jean Tirole, 2018. "Deadly Embrace: Sovereign and Financial Balance Sheets Doom Loops," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 85(3), pages 1781-1823.
    13. Markus K. Brunnermeier & Luis Garicano & Philip R. Lane & Marco Pagano & Ricardo Reis & Tano Santos & David Thesmar & Stijn Van Nieuwerburgh & Dimitri Vayanos, 2016. "The Sovereign-Bank Diabolic Loop and ESBies," American Economic Review, American Economic Association, vol. 106(5), pages 508-512, May.
    14. Carmen M. Reinhart & Kenneth S. Rogoff, 2014. "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises," Annals of Economics and Finance, Society for AEF, vol. 15(2), pages 215-268, November.
    15. Broner, Fernando & Erce, Aitor & Martin, Alberto & Ventura, Jaume, 2014. "Sovereign debt markets in turbulent times: Creditor discrimination and crowding-out effects," Journal of Monetary Economics, Elsevier, vol. 61(C), pages 114-142.
    16. Uribe, Martin & Yue, Vivian Z., 2006. "Country spreads and emerging countries: Who drives whom?," Journal of International Economics, Elsevier, vol. 69(1), pages 6-36, June.
    17. Niccolò Battistini & Marco Pagano & Saverio Simonelli, 2014. "Systemic risk, sovereign yields and bank exposures in the euro crisis [Real effects of the sovereign debt crises in Europe: evidence from syndicated loans]," Economic Policy, CEPR, CESifo, Sciences Po;CES;MSH, vol. 29(78), pages 203-251.
    18. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
    19. Neumeyer, Pablo A. & Perri, Fabrizio, 2005. "Business cycles in emerging economies: the role of interest rates," Journal of Monetary Economics, Elsevier, vol. 52(2), pages 345-380, March.
    20. Steven Ongena & Alexander Popov & Neeltje Van Horen, 2019. "The Invisible Hand of the Government: Moral Suasion during the European Sovereign Debt Crisis," American Economic Journal: Macroeconomics, American Economic Association, vol. 11(4), pages 346-379, October.
    21. Alter, Adrian & Schüler, Yves S., 2012. "Credit spread interdependencies of European states and banks during the financial crisis," Journal of Banking & Finance, Elsevier, vol. 36(12), pages 3444-3468.
    22. Reinhart, Carmen & Rogoff, Kenneth, 2009. "This Time It’s Different: Eight Centuries of Financial Folly-Preface," MPRA Paper 17451, University Library of Munich, Germany.
    23. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, vol. 24(Win), pages 14-23.
    24. Emmanuel Farhi & Jean Tirole, 2012. "Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts," American Economic Review, American Economic Association, vol. 102(1), pages 60-93, February.
    25. Calvo, Guillermo A, 1988. "Servicing the Public Debt: The Role of Expectations," American Economic Review, American Economic Association, vol. 78(4), pages 647-661, September.
    26. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "Varieties of Crises and Their Dates," Introductory Chapters, in: This Time Is Different: Eight Centuries of Financial Folly, Princeton University Press.
    27. Gertler, Mark & Kiyotaki, Nobuhiro, 2010. "Financial Intermediation and Credit Policy in Business Cycle Analysis," Handbook of Monetary Economics, in: Benjamin M. Friedman & Michael Woodford (ed.), Handbook of Monetary Economics, edition 1, volume 3, chapter 11, pages 547-599, Elsevier.
    28. Alexander Popov & Neeltje Van Horen, 2015. "Exporting Sovereign Stress: Evidence from Syndicated Bank Lending during the Euro Area Sovereign Debt Crisis," Review of Finance, European Finance Association, vol. 19(5), pages 1825-1866.
    29. Guido Sandleris, 2014. "Sovereign Defaults, Credit to the Private Sector, and Domestic Credit Market Institutions," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 46(2-3), pages 321-345, March.
    30. Reinhart, Carmen & Rogoff, Kenneth, 2009. "This Time It’s Different: Eight Centuries of Financial Folly-Chapter 1," MPRA Paper 17452, University Library of Munich, Germany.
    31. Cristina Arellano, 2008. "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, American Economic Association, vol. 98(3), pages 690-712, June.
    32. Matteo Crosignani, 2015. "Why Are Banks Not Recapitalized During Crises?," Working Papers 203, Oesterreichische Nationalbank (Austrian Central Bank).
    33. Russell Cooper & Kalin Nikolov, 2018. "Government Debt And Banking Fragility: The Spreading Of Strategic Uncertainty," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 59(4), pages 1905-1925, November.
    34. Acharya, Viral V. & Steffen, Sascha, 2015. "The “greatest” carry trade ever? Understanding eurozone bank risks," Journal of Financial Economics, Elsevier, vol. 115(2), pages 215-236.
    35. Viral V. Acharya & Hamid Mehran & Anjan V. Thakor, 2016. "Caught between Scylla and Charybdis? Regulating Bank Leverage When There Is Rent Seeking and Risk Shifting," The Review of Corporate Finance Studies, Society for Financial Studies, vol. 5(1), pages 36-75.
    36. Viral Acharya & Itamar Drechsler & Philipp Schnabl, 2014. "A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk," Journal of Finance, American Finance Association, vol. 69(6), pages 2689-2739, December.
    37. Sosa-Padilla, César, 2018. "Sovereign defaults and banking crises," Journal of Monetary Economics, Elsevier, vol. 99(C), pages 88-105.
    38. Demirgüç-Kunt, Asli & Kane, Edward J. & Laeven, Luc, 2008. "Determinants of deposit-insurance adoption and design," Journal of Financial Intermediation, Elsevier, vol. 17(3), pages 407-438, July.
    39. Harold L. Cole & Timothy J. Kehoe, 2000. "Self-Fulfilling Debt Crises," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 67(1), pages 91-116.
    40. Juan J. Cruces & Christoph Trebesch, 2013. "Sovereign Defaults: The Price of Haircuts," American Economic Journal: Macroeconomics, American Economic Association, vol. 5(3), pages 85-117, July.
    41. Eduardo Levy‐Yeyati & María Soledad Martínez Pería & Sergio L. Schmukler, 2010. "Depositor Behavior under Macroeconomic Risk: Evidence from Bank Runs in Emerging Economies," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(4), pages 585-614, June.
    42. Itamar Drechsler & Thomas Drechsel & David Marques-Ibanez & Philipp Schnabl, 2016. "Who Borrows from the Lender of Last Resort?," Journal of Finance, American Finance Association, vol. 71(5), pages 1933-1974, October.
    43. De Marco, Filippo, 2019. "Bank Lending and the European Sovereign Debt Crisis," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 54(1), pages 155-182, February.
    44. Keeley, Michael C, 1990. "Deposit Insurance, Risk, and Market Power in Banking," American Economic Review, American Economic Association, vol. 80(5), pages 1183-1200, December.
    45. Paul De Grauwe & Yuemei Ji, 2012. "Mispricing of Sovereign Risk and Macroeconomic Stability in the Eurozone," Journal of Common Market Studies, Wiley Blackwell, vol. 50(6), pages 866-880, November.
    46. Leonello, Agnese, 2018. "Government guarantees and the two-way feedback between banking and sovereign debt crises," Journal of Financial Economics, Elsevier, vol. 130(3), pages 592-619.
    47. V. V. Chari & Alessandro Dovis & Patrick J. Kehoe, 2016. "Financial Repression: Evidence and Theory," Economic Policy Paper 16-4, Federal Reserve Bank of Minneapolis.
    48. Luigi Bocola, 2016. "The Pass-Through of Sovereign Risk," Journal of Political Economy, University of Chicago Press, vol. 124(4), pages 879-926.
    49. Brutti, Filippo, 2011. "Sovereign defaults and liquidity crises," Journal of International Economics, Elsevier, vol. 84(1), pages 65-72, May.
    50. Filippo De Marco & Marco Macchiavelli, 2016. "The Political Origin of Home Bias: The Case of Europe," Finance and Economics Discussion Series 2016-060, Board of Governors of the Federal Reserve System (U.S.).
    51. Kareken, John H & Wallace, Neil, 1978. "Deposit Insurance and Bank Regulation: A Partial-Equilibrium Exposition," The Journal of Business, University of Chicago Press, vol. 51(3), pages 413-438, July.
    52. Ferrando, Annalisa & Popov, Alexander & Udell, Gregory F., 2015. "Sovereign stress, unconventional monetary policy, and SME access to finance," Working Paper Series 1820, European Central Bank.
    53. Gertler, Mark & Karadi, Peter, 2011. "A model of unconventional monetary policy," Journal of Monetary Economics, Elsevier, vol. 58(1), pages 17-34, January.
    54. Steven Ongena & Alexander Popov & Neeltje Van Horen, 2019. "The Invisible Hand of the Government: Moral Suasion during the European Sovereign Debt Crisis," American Economic Journal: Macroeconomics, American Economic Association, vol. 11(4), pages 346-379, October.
    55. Kevin C. Murdock & Thomas F. Hellmann & Joseph E. Stiglitz, 2000. "Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?," American Economic Review, American Economic Association, vol. 90(1), pages 147-165, March.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Affinito, Massimiliano & Albareto, Giorgio & Santioni, Raffaele, 2022. "Purchases of sovereign debt securities by banks during the crisis: The role of balance sheet conditions," Journal of Banking & Finance, Elsevier, vol. 138(C).
    2. Crosignani, Matteo, 2021. "Bank capital, government bond holdings, and sovereign debt capacity," Journal of Financial Economics, Elsevier, vol. 141(2), pages 693-704.
    3. Mr. Anil Ari & Sophia Chen & Mr. Lev Ratnovski, 2019. "The Dynamics of Non-Performing Loans during Banking Crises: A New Database," IMF Working Papers 2019/272, International Monetary Fund.
    4. Buch, Claudia M. & Koetter, Michael & Ohls, Jana, 2016. "Banks and sovereign risk: A granular view," Journal of Financial Stability, Elsevier, vol. 25(C), pages 1-15.
    5. Hodula Martin & Pfeifer Lukáš, 2018. "Fiscal-Monetary-Financial Stability Interactions in a Data-Rich Environment," Review of Economic Perspectives, Sciendo, vol. 18(3), pages 195-224, September.
    6. Ohls, Jana, 2017. "Moral suasion in regional government bond markets," Discussion Papers 33/2017, Deutsche Bundesbank.
    7. Matteo Crosignani, 2015. "Why Are Banks Not Recapitalized During Crises?," Working Papers 203, Oesterreichische Nationalbank (Austrian Central Bank).
    8. Ari, Anil, 2018. "Gambling traps," Working Paper Series 2217, European Central Bank.
    9. Andreas Jobst & Ms. Hiroko Oura, 2019. "Sovereign Risk in Macroprudential Solvency Stress Testing," IMF Working Papers 2019/266, International Monetary Fund.
    10. Corbisiero, Giuseppe, 2022. "Bank lending, collateral, and credit traps in a monetary union," European Economic Review, Elsevier, vol. 144(C).
    11. Carlos Alberto Piscarreta Pinto Ferreira, 2023. "Drivers of Sovereign Bond Demand – The Case of Japans," Working Papers REM 2023/0264, ISEG - Lisbon School of Economics and Management, REM, Universidade de Lisboa.
    12. Maria Manuel Campos & Ana Rita Mateus, 2019. "Sovereign exposures in the Portuguese banking system: determinants and dynamics," Working Papers w201916, Banco de Portugal, Economics and Research Department.
    13. Ari, Anil & Chen, Sophia & Ratnovski, Lev, 2021. "The dynamics of non-performing loans during banking crises: A new database with post-COVID-19 implications," Journal of Banking & Finance, Elsevier, vol. 133(C).
    14. Nadal De Simone, Francisco, 2021. "Measuring the deadly embrace: Systemic and sovereign risks," Research in International Business and Finance, Elsevier, vol. 56(C).

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Ari, Anil, 2018. "Gambling traps," Working Paper Series 2217, European Central Bank.
    2. Corbisiero, Giuseppe, 2022. "Bank lending, collateral, and credit traps in a monetary union," European Economic Review, Elsevier, vol. 144(C).
    3. Matteo Crosignani, 2015. "Why Are Banks Not Recapitalized During Crises?," Working Papers 203, Oesterreichische Nationalbank (Austrian Central Bank).
    4. Crosignani, Matteo & Faria-e-Castro, Miguel & Fonseca, Luís, 2020. "The (Unintended?) consequences of the largest liquidity injection ever," Journal of Monetary Economics, Elsevier, vol. 112(C), pages 97-112.
    5. Claudio Borio & Marc Farag & Fabrizio Zampolli, 2023. "Tackling the fiscal policy-financial stability nexus," BIS Working Papers 1090, Bank for International Settlements.
    6. Albertazzi, Ugo & Barbiero, Francesca & Marqués-Ibáñez, David & Popov, Alexander & Rodriguez d’Acri, Costanza & Vlassopoulos, Thomas, 2020. "Monetary policy and bank stability: the analytical toolbox reviewed," Working Paper Series 2377, European Central Bank.
    7. Carlo Altavilla & Marco Pagano & Saverio Simonelli, 2017. "Bank Exposures and Sovereign Stress Transmission," Review of Finance, European Finance Association, vol. 21(6), pages 2103-2139.
    8. Emmanuel Farhi & Jean Tirole, 2018. "Deadly Embrace: Sovereign and Financial Balance Sheets Doom Loops," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 85(3), pages 1781-1823.
    9. Occhino, Filippo, 2017. "The 2012 eurozone crisis and the ECB’s OMT program: A debt-overhang banking and sovereign crisis interpretation," European Economic Review, Elsevier, vol. 100(C), pages 337-363.
    10. Mitchener, Kris & Trebesch, Christoph, 2021. "Sovereign Debt in the 21st Century: Looking Backward, Looking Forward," CEPR Discussion Papers 15935, C.E.P.R. Discussion Papers.
    11. Spyros Alogoskoufis & Sam Langfield, 2020. "Regulating the Doom Loop," International Journal of Central Banking, International Journal of Central Banking, vol. 16(4), pages 251-292, September.
    12. Diego J. Perez, 2015. "Sovereign Debt, Domestic Banks and the Provision of Public Liquidity," Discussion Papers 15-016, Stanford Institute for Economic Policy Research.
    13. Crosignani, Matteo, 2021. "Bank capital, government bond holdings, and sovereign debt capacity," Journal of Financial Economics, Elsevier, vol. 141(2), pages 693-704.
    14. Luigi Bocola, 2016. "The Pass-Through of Sovereign Risk," Journal of Political Economy, University of Chicago Press, vol. 124(4), pages 879-926.
    15. Eijffinger, Sylvester C.W. & Karataş, Bilge, 2023. "Three sisters: The interlinkage between sovereign debt, currency, and banking crises," Journal of International Money and Finance, Elsevier, vol. 131(C).
    16. Vivek Sharma & Edgar Silgado-Gómez, 2019. "Sovereign Spread Volatility and Banking Sector," CEIS Research Paper 454, Tor Vergata University, CEIS, revised 08 Mar 2019.
    17. Kirschenmann, Karolin & Korte, Josef & Steffen, Sascha, 2020. "A zero-risk weight channel of sovereign risk spillovers," Journal of Financial Stability, Elsevier, vol. 51(C).
    18. Markus K. Brunnermeier & Sam Langfield & Marco Pagano & Ricardo Reis & Stijn Van Nieuwerburgh & Dimitri Vayanos, 2017. "ESBies: safety in the tranches," Economic Policy, CEPR, CESifo, Sciences Po;CES;MSH, vol. 32(90), pages 175-219.
    19. Kirschenmann, Karolin & Korte, Josef & Steffen, Sascha, 2017. "The zero risk fallacy? Banks' sovereign exposure and sovereign risk spillovers," ZEW Discussion Papers 17-069, ZEW - Leibniz Centre for European Economic Research.
    20. Leonello, Agnese, 2018. "Government guarantees and the two-way feedback between banking and sovereign debt crises," Journal of Financial Economics, Elsevier, vol. 130(3), pages 592-619.

    More about this item

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:red:sed016:676. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Christian Zimmermann (email available below). General contact details of provider: https://edirc.repec.org/data/sedddea.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.