Sovereign Risk and Bank Risk-Taking

Anil Ari

No 676, 2016 Meeting Papers from Society for Economic Dynamics

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.

Date: 2016
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge and nep-eec
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Related works:
Working Paper: Sovereign risk and bank risk-taking (2018)
Working Paper: Sovereign Risk and Bank Risk-Taking (2017)
Working Paper: Sovereign Risk and Bank Risk-Taking (2016)
Working Paper: Sovereign risk and bank risk-taking (2016)
Working Paper: Sovereign Risk and Bank Risk-Taking (2016)
Working Paper: Sovereign Risk and Bank Risk-Taking (2015)
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed016:676

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