Bank and Sovereign Debt Risk Connection

SAFE Working Paper No. 7

44 Pages Posted: 6 Mar 2013 Last revised: 11 Mar 2014

Matthieu Darracq Paries

European Central Bank (ECB)

Ester Faia

Goethe University Frankfurt; Kiel Institute for the World Economy; French National Center for Scientific Research (CNRS) - Centre d'Etudes Prospectives d'Economie Mathematique Appliquees a la Planification (CEPREMAP)

Diego Rodriguez-Palenzuela

European Central Bank (ECB)

Date Written: November 1, 2013

Abstract

Euro area data show a positive connection between sovereign and bank risk, which increases with banks’ and sovereign long run fragility. We build a macro model with banks subject to moral hazard and liquidity risk (sudden deposit withdrawals): banks invest in risky government bonds as a form of capital buffer against liquidity risk. The model can replicate the positive connection between sovereign and bank risk observed in the data. Central bank liquidity policy, through full allotment policy, is successful in stabilizing the spiraling feedback loops between bank and sovereign risk.

Keywords: liquidity risk, sovereign risk, capital regulations

JEL Classification: E5, G3, E6

Suggested Citation

Darracq Paries, Matthieu and Faia, Ester and Rodriguez-Palenzuela, Diego, Bank and Sovereign Debt Risk Connection (November 1, 2013). SAFE Working Paper No. 7. Available at SSRN: https://ssrn.com/abstract=2228494 or http://dx.doi.org/10.2139/ssrn.2228494

Matthieu Darracq Paries

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
+496913446631 (Phone)
+496913447604 (Fax)

Ester Faia (Contact Author)

Goethe University Frankfurt ( email )

Grüneburgplatz 1
Frankfurt am Main, 60323
Germany

Kiel Institute for the World Economy

P.O. Box 4309
Kiel, D-24100
Germany

French National Center for Scientific Research (CNRS) - Centre d'Etudes Prospectives d'Economie Mathematique Appliquees a la Planification (CEPREMAP)

Ecole Normale Superieure
48 boulevard Jourdan
75014 Paris
France

Diego Rodriguez-Palenzuela

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
(49) 69-1344-6480 (Phone)
(49) 69-1344-6575 (Fax) (Fax)

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