Bank Lending and the European Sovereign Debt Crisis

Abstract

I investigate the relationship between the sovereign debt crisis and the credit crunch in Europe. Using data on banks’ exposure to government debt, I show that banks more exposed to the sovereign shock tightened credit supply by more than banks that were less exposed. This happens both though credit quantities and prices, even controlling for a firm fixed effect. I further show that there are negative real effects for small firms borrowing from the affected banks, even in countries not under sovereign stress. The results are also robust to instrumenting the level of sovereign exposure with banks’ government ownership. The data suggest that banks’ sovereign exposures mattered for the credit crunch because they increased banks’ cost of funding rather than affecting banks’ equity.