Sovereign risk and bank lending: evidence from 1999 Turkish earthquake

We use an exogenous fiscal shock to identify the transmission of government risk to bank lending due to banks holding government bonds. We illustrate with a theoretical model that for banks with higher exposure to government bonds, a higher sovereign default risk implies lower bank net worth and less lending. Our empirical estimates confirm the model's predictions. The exogenous change in sovereign default risk of Turkish government debt as a result of the 1999 Earthquake impacts banks whose balance sheets were exposed more to government bonds. The resulting lower bank net worth translates into lower credit supply. We rule out alternative explanations. Our estimates suggest this channel can explain half of the decline in bank lending following the earthquake. This underlines the importance of the bank balance-sheet channel in transmitting a higher sovereign default risk to reduced real economic activity.