The Pass-Through of Sovereign Risk

This paper examines the aggregate implications of sovereign credit risk in a business cycle model in which banks are exposed to risky government debt. An increase in the probability of a future sovereign default leads to a reduction in credit to firms because of two channels. First, it lowers the value of government debt on the balance sheet of banks, tightening their funding constraints and leaving them with fewer resources to lend to firms. Second, it raises the required premia demanded by banks for lending to firms because this activity has become riskier: if the sovereign default occurs, the economy falls in a major recession and claims to the productive sector pay out little. I estimate the nonlinear model with Italian data using Bayesian techniques. I find that sovereign credit risk led to a rise in the financing premia of firms that peaked 100 basis points, and cumulative output losses of 4.75% by the end of 2011. Both channels were quantitatively important drivers of the propagation of sovereign credit risk to the real economy. I then use the model to evaluate the effects of subsidized long term loans to banks, calibrated to the ECB's Longer Term Refinancing Operations. The presence of a significant risk channel at the policy enactment explains the limited stimulative effects of these interventions.