The Sovereign-Bank Nexus, Credit Cycles and Macroprudential Policy
This paper studies the macro-financial implications of the sovereign-bank nexus and its relevance for macroprudential policy design, with a focus on emerging market economies (EMEs). Using a panel of advanced and emerging economies, I document that banks’ exposure to government debt has increased steadily over the past decade, particularly in EMEs. I find that sovereign-bank exposure, sovereign risk, and government debt are significant drivers of the credit cycle in EMEs, but not in advanced economies (AEs). These relationships are nonlinear, with stronger effects during credit booms. To explain these findings, I explore credit dynamics in a model where banks must allocate funds between sovereign bonds and private lending subject to capital requirements and sovereign default risk. Future work will assess optimal macroprudential policy in this environment.