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.