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Sovereign Risk and Bank Risk-Taking

Author

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  • Anil Ari

    () (Faculty of Economics, University of Cambridge)

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. This paper examines the banking equilibrium in a model with optimizing banks and depositors, deriving implications for economic vulnerability to crisis and policy design. It shows that under-capitalized banks have an incentive to gamble on domestic sovereign bonds when they expect to suffer from non-bond losses in the aftermath of sovereign default. Depositor reactions to insolvency risk impose discipline, but also leave the economy susceptible to self-fulfilling shifts in sentiments, where sovereign default also causes a banking crisis. In an adverse equilibrium, sovereign risk shocks simultaneously raise bank funding costs and drive banks to increase their purchases of domestic debt, crowding out bank lending. Subsidized loans to banks, similar to the ECB's non-targeted longer-term refinancing operations (LTRO), strengthen gambling incentives and may even eliminate the good equilibrium. Targeted interventions have the capacity to eliminate adverse equilibria.

Suggested Citation

  • Anil Ari, 2015. "Sovereign Risk and Bank Risk-Taking," Working Papers 202, Oesterreichische Nationalbank (Austrian Central Bank).
  • Handle: RePEc:onb:oenbwp:202
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    File URL: https://www.oenb.at/dam/jcr:a5e4a781-63fa-456f-8020-d997cf76531f/Working%20Paper%20202.pdf
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    Cited by:

    1. Buch, Claudia M. & Koetter, Michael & Ohls, Jana, 2016. "Banks and sovereign risk: A granular view," Journal of Financial Stability, Elsevier, vol. 25(C), pages 1-15.

    More about this item

    Keywords

    Sovereign Debt Crises; Bank Risk-Taking; Financial Constraints; Eurozone;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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