Sovereign Risk and Bank Risk-Taking

Résumé

I propose a general equilibrium macroeconomic model in which strategic interactions between banks and depositors may lead to endogenous bank fragility and default, associated with a persistent drop in investment and output. With some opacity in bank balance sheets, depositors form expectations about bank risk-taking and demand a return on bank deposits according to their risk. This creates strategic complimentarities and possibly multiple equilibria: in response to an increase in funding costs, banks may optimally choose to pursue risky portfolios that undermine their solvency prospects. I bring the model to bear on the European sovereign debt crisis, in the course of which under-capitalized banks in default-risky countries experienced an increase in funding costs and raised their holdings of domestic government debt. The model is quantified using Portuguese data and accounts for macroeconomic dynamics in Portugal in 2010-2016. Policy interventions face a trade-off between alleviating banks' funding conditions and strengthening risk-taking incentives. Liquidity provision to banks may eliminate the good equilibrium when not targeted. Targeted interventions have the capacity to eliminate adverse equilibria.