Banks, Sovereign Debt and Capital Requirements

Abstract

In the aftermath of the Great Recession of 2007-2009, Europe has been grappling with both a debt and a banking crisis, which caused a prolonged recession and on-going stagnation in some countries of the Eurozone. The distinctive feature of the European crisis, compared to the global recession that originated in the United States, is that it emerged as sovereign debt crisis and later evolved into a banking crisis, finally affecting the real economy. The banking and sovereign crises are heavily intertwined because of the interplay between banks and sovereigns in Europe. In fact, the so-called bank-sovereign nexus works both ways: not only banks hold large amounts of sovereign debt, especially from the domestic government, but also European governments retain a significant presence in the domestic banks' ownership. The adverse feedback loop is reinforced during a sovereign debt crisis, as banks' losses from sovereign debt further exacerbate the strain on the domestic sovereign in expectation of a future bail-out. The overall goal of this dissertation is to have a better understanding of the interplay between sovereign, banks and capital regulation. In my first and second chapter, I analyze the two-way feedback loop between banks and sovereigns in Europe. In particular, in the first chapter, I show that banks' sovereign debt exposures had a negative effect on credit supply during the crisis. In the second chapter I explore the role that politics may play in determining banks' exposure to sovereign debt. Finally, the third chapter investigates the effect of changing bank capital requirements for the firms that borrow from the affected banks.