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Sovereign risk, bank funding and investors' pessimism

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  • Faia, Ester

Abstract

Data show that sovereign risk reduces liquidity, increases funding cost and risk of banks highly exposed to it. I build a model that rationalizes this fact. Banks act as delegated monitors and invest in risky projects and in risky sovereign bonds. As investors hear rumors of increased sovereign risk, they run the bank (via global games). Banks could rollover liquidity in repo market using government bonds as collateral, but as sovereign risk raises collateral values shrink. Overall banks' liquidity falls (its cost increases) and so does banks' credit. In this context noisy news (announcements with signal extraction) of consolidation policies are recessionary in the short run, as they contribute to investors and banks pessimism, and mildly expansionary in the medium run. The banks liquidity channel plays a major role in the fiscal transmission.

Suggested Citation

  • Faia, Ester, 2016. "Sovereign risk, bank funding and investors' pessimism," CFS Working Paper Series 542, Center for Financial Studies (CFS).
    • Handle: RePEc:zbw:cfswop:542
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    Cited by:

    1. Perego, Erica, 2020. "Sovereign risk and asset market dynamics in the euro area," Journal of International Money and Finance, Elsevier, vol. 109(C).
    2. Leonello, Agnese, 2018. "Government guarantees and the two-way feedback between banking and sovereign debt crises," Journal of Financial Economics, Elsevier, vol. 130(3), pages 592-619.
    3. Yao Hongxing & Zou Yushi, 2019. "Research on Rumor Spreading Model with Time Delay and Control Effect," Journal of Systems Science and Information, De Gruyter, vol. 7(4), pages 373-389, August.
    4. Darracq Pariès, Matthieu & Müller, Georg & Papadopoulou, Niki, 2023. "Fiscal multipliers within the euro area in the context of sovereign risk and bank fragility," Economic Modelling, Elsevier, vol. 126(C).
    5. María Cantero‐Saiz & Sergio Sanfilippo‐Azofra & Begoña Torre‐Olmo, 2022. "Sovereign Risk and the Bank Lending Channel: Differences across Countries and the Effects of the Financial Crisis," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 54(1), pages 285-312, February.
    6. Matthieu Darracq Paries & Georg Muller & Niki Papadopoulou, 2022. "Fiscal Multipliers with Sovereign Risk and Fragile Banks," Working Papers 2022-5, Central Bank of Cyprus.
    7. Emanuele Bacchiocchi & Catalin Dragomirescu-Gaina, 2021. "Uncertainty spill-overs: when policy and financial realms overlap," Papers 2102.06404, arXiv.org.
    8. Beqiraj, Elton & Fedeli, Silvia & Tancioni, Massimiliano, 2021. "Fiscal retrenchments and the transmission mechanism of the sovereign risk channel for highly indebted countries," The North American Journal of Economics and Finance, Elsevier, vol. 57(C).

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    More about this item

    Keywords

    liquidity risk; sovereign risk; banks' funding costs;
    All these keywords.

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G3 - Financial Economics - - Corporate Finance and Governance
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook

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