Journal Article

Transmission of Sovereign Risk to Bank Lending

Abstract: Banks hold a significant exposure to their own sovereigns. An increase in sovereign risk may hurt banks' balance sheets, causing a decrease in lending and a decline in economic activity. We quantify the transmission of sovereign risk to bank lending and provide new evidence about the effect of sovereign risk on economic outcomes. We consider the 1999 Marmara earthquake in Turkey as an exogenous shock leading to an increase in Turkey's default risk. Our empirical estimates show that, for banks holding a higher amount of government securities, the exogenous change in sovereign default risk tightens banks' financial constraints significantly. The banks' resulting tighter financial constraints translate into lower credit provision, suggesting that there is a significant balance-sheet channel in transmitting a higher sovereign default risk toward real economic activity.

Keywords: banking crisis; bank balance sheets; lending channel; public debt; credit supply;

JEL Classification: E32; F15; F36; O16;

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Bibliographic Information

Provider: Federal Reserve Bank of Atlanta

Part of Series: Policy Hub

Publication Date: 2023-02-27

Volume: 2023

Issue: 2

Order Number: 2023-02