Discussion paper

DP11340 Sovereign Risk, Bank Funding and Investors’ Pessimism

Data show that sovereign risk reduces liquidity, increases funding cost and risk of banks
highly exposed to it. A feedback loop exists between sovereign and bank risk. I build a model
that rationalizes those links. 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 policy 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.

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Citation

Faia, E (2016), ‘DP11340 Sovereign Risk, Bank Funding and Investors’ Pessimism‘, CEPR Discussion Paper No. 11340. CEPR Press, Paris & London. https://cepr.org/publications/dp11340