Sovereign Risk and Bank Risk-Taking

55 Pages Posted: 17 Jun 2016

See all articles by Anil Ari

Anil Ari

International Monetary Fund

Multiple version iconThere are 3 versions of this paper

Date Written: April 25, 2016

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, 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-fulfilling 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.

Keywords: Sovereign Debt Crises, Bank Risk-Taking, Financial Constraints, Eurozone

JEL Classification: E44, E58, F34, G21, H63

Suggested Citation

Ari, Anil, Sovereign Risk and Bank Risk-Taking (April 25, 2016). ECB Working Paper No. 1894, Available at SSRN: https://ssrn.com/abstract=2769996

Anil Ari (Contact Author)

International Monetary Fund ( email )

700 19th Street NW
Washington, DC 20431
United States

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