Sovereign Risk and Bank Lending: Theory and Evidence from a Natural Disaster
February 09, 2023
Summary
Examining the relationship between sovereign risk and bank lending, the authors of this working paper find that for banks with higher exposure to government securities, a higher sovereign default risk implies lower net worth and tightening financial constraint, which lead to lower credit provision.
View PaperWorking Paper 2023-1
Abstract: We quantify the sovereign-bank doom loop by using the 1999 Marmara earthquake as an exogenous shock leading to an increase in Turkey's default risk. Our theoretical model illustrates that for banks with higher exposure to government securities, a higher sovereign default risk implies lower net worth and tightening financial constraint. Our empirical estimates confirm the model's predictions, showing 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.
JEL classification: E32, F15, F36, O16
Key words: crisis, bank balance sheets, lending channel, public debt, credit supply
Digital Object Identifier: https://doi.org/10.29338/wp2023-01
The authors thank Daron Acemoglu, Mark Aguiar, Koray Alper, Erdem Basci, V.V. Chari, Stijn Claessens, Giancarlo Corsetti, Raquel Fernandez, Jose Louis DePeydro, Linda Goldberg, Anne Krueger, Alberto Martin, Atif Mian, Pablo Ottonello, Radek Paluszynski, Richard Portes, Ken Rogoff, Larry Wall, and the participants at various conferences for their comments. The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System.
Yusuf Soner Baskaya is with the Adam Smith Business School at the University of Glasgow. Bryan Hardy is with the Bank for International Settlements. Sebnem Kalemli-Özcan is with the University of Maryland, the Center for Economic and Policy Research, and the National Bureau of Economic Research. Please address questions regarding content to Vivian Yue, Emory University, the Federal Reserve Bank of Atlanta, the Center for Economic and Policy Research, and the National Bureau of Economic Research.
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