Abstract
This paper examines the macroeconomic implications of sovereign credit risk in a business cycle
model where banks are exposed to domestic government debt. The news of a future sovereign default
hampers financial intermediation. First, it tightens the funding constraints of banks, reducing
their available resources to finance firms (liquidity channel). Second, it generates a precautionary
motive for banks to deleverage (risk channel). I estimate the model using Italian data, finding
that i) sovereign credit risk was recessionary and that ii) the risk channel was sizable. I then use
the model to evaluate the effects of subsidized long term loans to banks, calibrated to the ECB’s
longer-term refinancing operations. The presence of strong precautionary motives at the time of
policy enactment implies that bank lending to firms is not very sensitive to these credit market
interventions.
Published In: Journal of Political Economy (Vol. 124, No. 4, 2016, pp. 879-926)
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