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Liquidity pressure and the sovereign-bank diabolic loop

Author

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  • Janbaz, M.
  • Hassan, M.K.
  • Floreani, J.
  • Dreassi, A.

Abstract

We study the sovereign-bank nexus through the liquidity channel. Using a sample of 22 European economies during 2012–2021, we find that an increase in banking liquidity pressures leads to a significant widening of SCDS spreads as banks are encouraged to purchase sovereign bonds for liquidity management purposes, consistent with the "flight to liquidity" phenomenon. This excessive exposure increases the probability of sovereign default in the long run by reducing the sustainability of sovereign debt and evoking a diabolic loop scenario. The results also suggest that ECB intervention can reinforce the feedback loop by lowering funding costs and triggering collateral trading.

Suggested Citation

  • Janbaz, M. & Hassan, M.K. & Floreani, J. & Dreassi, A., 2024. "Liquidity pressure and the sovereign-bank diabolic loop," International Review of Economics & Finance, Elsevier, vol. 93(PA), pages 1039-1057.
    • Handle: RePEc:eee:reveco:v:93:y:2024:i:pa:p:1039-1057
    DOI: 10.1016/j.iref.2024.04.016
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    More about this item

    Keywords

    Sovereign-bank nexus; Liquidity pressure; ECB intervention; Flight to liquidity; Diabolic loop;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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