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21 August 2015

ECB: Working Paper Series - Sovereign risk, interbank freezes, and aggregate fluctuation

Default: Change to:

This European Central Bank paper studies the interaction of sovereign default risk with the banking sector. Authors present a model with strategic default on public debt in which sovereign risk adversely affects funding conditions of banks on the interbank market.

Authors model a government that cannot credibly commit to repay its outstanding debt. The risk of a sovereign default arises due to an endogenous outcome of an optimal decision of the government to service the outstanding debt. Since government bonds are used as collateral on the interbank market, they are essential for the re-allocation of financial resources within the economy by providing liquidity services to the banking sector. An ensuing credit crunch arising in default episodes acts as an ex post penalty and disciplines governments to service their debt obligations. As a result, the government is willing to borrow high amounts in order to relax borrowing constraints in the private sector. The government is able to do so since the enforcement problem is mitigated by the endogenous penalty.

In this setting, government debt turns fragile due to ex ante spillovers of sovereign risk to bank funding conditions that lead to an amplification effect on aggregate shocks:

A risk premium on secured interbank debt pushes up financing costs in the non-financial sector. This friction leads to less intermediation on the interbank market.

The limitation of credit supply gives rise to a drop in output. As a result, the original penalty turns less painful in the presence of ex ante spillovers, making default even more likely and leading to a downward spiral.

The model is calibrated to Spanish data over the time period 2000-11 at a quarterly frequency.  In line with the model predictions in the presence of a cyclical default penalty, the weak growth performance in peripheral euro area countries is important to rationalize the observed increases in sovereign bond yield spreads. In the presence of ex ante spillovers of sovereign risk, banks have difficulties in tapping wholesale funding markets, which drives up bank funding costs. Thereby, the collateral channel of sovereign risk is able to explain the co-movement of private and public sector interest rates during times of intense fiscal stress and as observed in the Euro Area.

By providing a structural explanation for the complex interactions of fiscal policy, financial stability, and macroeconomic outcomes, the framework deepens the understanding of highly non-linear systemic crises.  The model can be employed to help policymakers design more effective crisis intervention policies and to address shortcomings in the existing institutional framework.

Full working paper

© ECB - European Central Bank

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