Transmission of Sovereign Risk to Bank Lending

February 27, 2023

Yusuf Soner Bașkaya University of Glasgow

Bryan Hardy Bank for International Settlements

Vivian Yue Emory University, the National Bureau of Economic Research, and the Center for Economic and Policy Research

Şebnem Kalemli-Özcan Brown University and Global Linkages Lab; National Bureau of Economic Research (NBER); Center for Economic Policy Research (CEPR)

Summary

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.

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Policy Hub 2023-3

Key findings:

We show that the exogenous change in sovereign default risk tightens banks' financial constraints significantly for banks that hold a higher amount of government securities.
The resulting tighter bank 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.

Center Affiliation: Center for Quantitative Economic Research

JEL classification: E32, F15, F36, O16

Key words: banking crisis, bank balance sheets, lending channel, public debt, credit supply

Digital Object Identifier: https://doi.org/10.29338/ph2023-02