Liquidity pressure and the sovereign-bank diabolic loop

Abstract

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.