Managing the Sovereign-Bank Nexus

Abstract

This paper identifies the various channels that give rise to a "sovereign-bank nexus" whereby the financial health of banks and sovereigns is intertwined. We find that banks and sovereigns are linked by three interacting channels: banks hold large amounts of sovereign debt; banks are protected by government guarantees; and the health of banks and governments affect and is affected by economic activity. Evidence suggests that all three channels are relevant. The paper concludes with a discussion of the policy implications of these findings.

Liquidation Value and Loan Pricing

“…The underlying assumption is that there is a strong positive relation between the default risk of a bank and the default risk of its home country, as widely documented in the literature on the sovereign‐bank nexus (see, e.g., Dell'Ariccia et al. (2018)).…”

“…We capture the correlation between collateral and borrower risk by constructing a High-correlation dummy that is equal to one if the borrower is of the same country as the collateral issuer, and to zero otherwise. The underlying assumption is that there is a strong positive relation between the default risk of a bank and the default risk of its home country, as widely documented in the literature on the sovereign-bank nexus (see, e.g., Dell'Ariccia et al (2018)).…”

“…Existing literature on the bank‐sovereign nexus mainly considers the impact of home bias on banks' market value (Dell'Ariccia et al. (2018)), lending (Popov and van Horen (2014), Altavilla, Pagano, and Simonelli (2017), Gennaioli, Martin, and Rossi (2018), De Marco (2019)), and the real economy (Acharya et al. (2018), Bottero, Lenzu, and Mezzanotti (2020)).…”

Heterogeneity and dynamics in network models

“…Financial system interconnectedness can be regarded as one of the prominent determinants for sovereign credit risk spillovers given the bail‐out incentive of governments for their local banking sector, and its potential effects on government creditworthiness. See, for instance, the overview of Dell'Ariccia et al (2018) on the bank‐sovereign nexus and the importance of bank exposure networks on perceived sovereign credit quality. Bank cross‐exposures have also been used in other spatial financial network models such as Elliott et al (2014) and Denbee et al (2021) to give a structural interpretation to the shocks in the spatial model.…”