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.
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
https://doi.org/10.29338/ph2023-02