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The Pass-Through of Sovereign Risk

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  • Luigi Bocola

Abstract

This paper examines the macroeconomic implications of sovereign credit risk in a business cycle model where banks are exposed to domestic government debt. The news of a future sovereign default hampers financial intermediation. First, it tightens the funding constraints of banks, reducing their available resources to finance firms (liquidity channel). Second, it generates a precautionary motive for banks to deleverage (risk channel). I estimate the model using Italian data, finding that i) sovereign credit risk was recessionary and that ii) the risk channel was sizable. 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 strong precautionary motives at the time of policy enactment implies that bank lending to firms is not very sensitive to these credit market interventions.

Suggested Citation

  • Luigi Bocola, 2015. "The Pass-Through of Sovereign Risk," Working Papers 722, Federal Reserve Bank of Minneapolis.
  • Handle: RePEc:fip:fedmwp:722
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    More about this item

    Keywords

    Sovereign debt crises; Financial constraints; Risk; Credit policies;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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