Sovereign Risk, Bank Funding and Investors’ Pessimism

44 Pages Posted: 9 Oct 2016 Last revised: 18 Jan 2018

See all articles by Ester Faia

Ester Faia

Goethe University Frankfurt; Centre for Economic Policy Research (CEPR)

Date Written: September 30, 2016

Abstract

Data show that sovereign risk reduces liquidity, 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 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 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.

Keywords: liquidity risk, sovereign risk, banks’ funding costs

JEL Classification: E5, G3, E6

Suggested Citation

Faia, Ester, Sovereign Risk, Bank Funding and Investors’ Pessimism (September 30, 2016). CFS Working Paper, No. 542, Available at SSRN: https://ssrn.com/abstract=2849031 or http://dx.doi.org/10.2139/ssrn.2849031

Ester Faia (Contact Author)

Goethe University Frankfurt ( email )

Grüneburgplatz 1
Frankfurt am Main, 60323
Germany

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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