DP11340 Sovereign Risk, Bank Funding and Investors' Pessimism

Author(s):	Ester Faia
Publication Date:	June 2016
Keyword(s):	banks' funding costs, feedback loops, liquidity risk, repo freezes, sovereign risk
JEL(s):	E5, E6, G3
Programme Areas:	Financial Economics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=11340

Evidence shows that sovereign risk increases funding cost and risk of banks highly exposed to it. I build a model that rationalizes this fact. Banks act as delegated monitors and invest in risky projects and in risky sovereign bonds. As investors hear rumors of increased asset risk, they run the bank through an information coordination game. 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 policies 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.