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Keynes Fund

 

Project Summary

Anil Ari - Sovereign Risk & Bank Risk-Taking (JHOE)

The original proposal entailed a research project analysing the interactions between sovereign risk and bank risk-taking. The proposal consisted of two components: a theoretical component pertaining to the development of a model analysing bank incentives during sovereign debt crises, and an empirical component aiming to test implications from this model using data from recent ECB and EBA stress tests.

As originally proposed, the Keynes Fund grant was used to hire a research assistant for data collection as well as dissemination activities. The project was presented widely in departmental seminars and conferences as well as being circulated as a working paper.

Research Output

Sovereign Risk and Bank Risk-Taking, Anil Ari (2017)

Abstract: I propose a dynamic general equilibrium model in which strategic interactions between banks and depositors may lead to endogenous bank fragility and slow recovery from crises. When banks' investment decisions are not contractible, depositors form expectations about bank risk-taking and demand a return on deposits according to their risk. This creates strategic complementarities 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. In a bad equilibrium, high funding costs hinder the accumulation of bank net worth, leading to a persistent drop in investment and output. 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.

IMF Working Paper link