Sovereign Risk and Bank Risk-Taking

Abstract

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in AbstractIn 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 …nancial 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, under-capitalized 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-ful…lling shifts in sentiments, where sovereign default also causes a banking crisis. Policy interventions face a trade-o¤ 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. Non-Technical SummarySince the eruption of the European debt crisis, the share of domestic sovereign debt held by the national banking system has increased sharply in crisis-hit countries. This created a dangerous nexus between the …nancial health of banks and sovereigns, and was associated with a rise in bank funding costs and the crowding out of bank lending to the private sector. The high exposure of banks in crisis-hit countries to domestic sovereign debt is indeed considered a key, if not the key, source of instability in the recent European sovereign debt crisis (see e.g. Acharya et al., 2014;Farhi & Tirole, 2015;Brunnermeier et al., 2016). The question is then why have banks in the crisis-hit countries become so highly exposed to domestic sovereign debt. In this paper, I address this question from a novel angle, calling attention to the interactions between banks and depositors, each optimizing their portfolio strategies vis-à-vis the prospect of a sovereign debt crisis. I develop my analysis specifying a small open economy model with three private agents, households, banks, and non-…nancial …rms, and a government issuing default-risky debt. For the sake of clarity and analytical tractability, I focus on a two period economy. In the …rst period, banks collect deposits from households and allocate their funds between domestic sovereign bond purchases and lending to …rms in need of working capital...

Why Are Banks Not Recapitalized During Crises?

“…4 The literature has also attributed the increased holdings of risky government bonds during sovereign crises to their collateral role for interbank loans (Bolton and Jeanne (2011)), their collateral eligibility at the central bank (Uhlig (2013)), and the lack of balance sheet transparency (Ari (2017)). …”

The Dynamics of Non-Performing Loans during Banking Crises

“…First, high public debt reduces the government's fiscal space, limiting its ability to cushion the fallout from the banking crisis fiscally. Second, high public debt may induce a sovereign-bank nexus where banks increase their domestic sovereign bond purchases due to government pressure or in a gamble for resurrection, thereby crowding out new credit to the private sector (Acharya et al 2018;Ari, 2017).…”

Sovereign Risk in Macroprudential Solvency Stress Testing

“…Doing so becomes more attractive when returns from loans and alternative assets are low, 76 and when short-term rates (the cost of carrying) are low. 77 Moreover, banks may take an excessive carry trade risk when their capitalization is already low, and risk-shifting incentives encouraging "gambling for resurrection" (due to limited liability) are strong (Ari 2017). The expectation of bailout or forbearance in the event of a sovereign default could also encourage excessive carry trades.…”