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Sovereign Risk, Interbank Freezes, and Aggregate Fluctuations

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  • Philipp Engler
  • Christoph Große Steffen

Abstract

This paper studies the bank-sovereign link in a dynamic stochastic general equilibrium set-up with strategic default on public debt. Heterogeneous banks give rise to an interbank market where government bonds are used as collateral. A default penalty arises from a breakdown of interbank intermediation that induces a credit crunch. Government borrowing under limited commitment is costly ex ante as bank funding conditions tighten when the quality of collateral drops. This lowers the penalty from an interbank freeze and feeds back into default risk. The arising amplification mechanism propagates aggregate shocks to the macroeconomy. The model is calibrated using Spanish data and is capable of reproducing key business cycle statistics alongside stylized facts during the European sovereign debt crisis.

Suggested Citation

  • Philipp Engler & Christoph Große Steffen, 2014. "Sovereign Risk, Interbank Freezes, and Aggregate Fluctuations," Discussion Papers of DIW Berlin 1436, DIW Berlin, German Institute for Economic Research.
  • Handle: RePEc:diw:diwwpp:dp1436
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    3. Irina Balteanu & Aitor Erce, 2018. "Linking Bank Crises and Sovereign Defaults: Evidence from Emerging Markets," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 66(4), pages 617-664, December.
    4. Guo, Yanling, 2015. "A reconsideration of multiple equilibria in the analysis of one-period government bonds with default risk," Economics - The Open-Access, Open-Assessment E-Journal (2007-2020), Kiel Institute for the World Economy (IfW), vol. 9, pages 1-52.
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    7. Christoph Große Steffen & Maximilian Podstawski, 2016. "Ambiguity and Time-Varying Risk Aversion in Sovereign Debt Markets," Discussion Papers of DIW Berlin 1602, DIW Berlin, German Institute for Economic Research.
    8. Occhino, Filippo, 2017. "The 2012 eurozone crisis and the ECB’s OMT program: A debt-overhang banking and sovereign crisis interpretation," European Economic Review, Elsevier, vol. 100(C), pages 337-363.
    9. Louri, Helen & Migiakis, Petros, 2019. "Financing economic activity in Greece: past challenges and future prospects," LSE Research Online Documents on Economics 102644, London School of Economics and Political Science, LSE Library.
    10. G. Chiesa & J. M. Mansilla-Fernández, 2018. "Non-Performing Loans, Cost of Capital, and Lending Supply: Lessons from the Eurozone Banking Crisi," Working Papers wp1124, Dipartimento Scienze Economiche, Universita' di Bologna.
    11. Palmén, Olli, 2020. "Sovereign default risk and credit supply: Evidence from the euro area," Journal of International Money and Finance, Elsevier, vol. 109(C).
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    14. Große Steffen, Christoph, 2015. "Uncertainty shocks and non-fundamental debt crises: An ambiguity approach," VfS Annual Conference 2015 (Muenster): Economic Development - Theory and Policy 112936, Verein für Socialpolitik / German Economic Association.
    15. Gabriella CHIESA & José Manuel MANSILLA-FERNÁNDEZ, 2018. "Non-Performing Loans, Cost of Capital, and Lending Supply: Lessons from the Eurozone Banking Crisis," Departmental Working Papers 2018-05, Department of Economics, Management and Quantitative Methods at Università degli Studi di Milano.
    16. Helen Louri & Petros Migiakis, 2019. "Financing economic growth in Greece: lessons from the crisis," Working Papers 262, Bank of Greece.
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    More about this item

    Keywords

    Sovereign default; interbank market; bank-sovereign link; Non-Ricardian effects; secondary markets; domestic debt; occasionally binding constraint;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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