Liquidity pressure and the sovereign-bank diabolic loop.

EUROPEAN Central Bank; BANK management; LIQUIDITY (Economics); BANKING industry; GOVERNMENT securities; SPREAD (Finance); BANK liquidity; PUBLIC debts

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. • We find robust evidence of the sovereign-bank nexus via the liquidity management channel. • Banking sector liquidity shocks significantly widen SCDS spreads. • ECB interventions amplify the feedback loop, particularly where asset purchases under a policy are substantial. [ABSTRACT FROM AUTHOR]

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