Fiscal stance and the sovereign risk pass-through

Abstract

Sovereign risk surges are tightly linked to bank risk and primary deficits during crises. While the literature documents this unconditional evidence, identification of the main channels driving the state of the sovereign-bank risk pass-through and its fiscal premia component remains an open issue. We estimate a Markov-switching VAR on Italian data for the period 1990–2019 to describe the run up of sovereign and bank credit risk in an environment where regime switches determine the extent to which the fiscal stance feeds risk. We find that a model displaying recurrent regimes affecting both shocks’ sizes and the transmission mechanism between fundamentals and spreads best explain the data. Stress states of heightened risk amplification and a modest role for fundamentals are historically identified. These states feature increased risk sensitivity to primary deficits and to fiscal multipliers, and a tighter sovereign-bank risk pass-through.