Ricerc@Sapienza

This paper presents a unified analysis of the run-up of sovereign and credit risk in an environment where latent factors, along with fundamentals, feed financial crises. A Markov-switching VAR in four variables (debt, GDP, sovereign and corporate spreads) is estimated on Italian 1990-2018 data.

We test whether adverse changes to banks’ market valuations during the financial and sovereign debt crises affected firms’ real decisions. Using new data linking over 5000 non-financial Italian firms to their bank(s), we find that increases in banks’ CDS spreads, and decreases in their equity valuations, resulted in lower investment, employment, and bank debt for younger and smaller firms. These effects dominate those of banks’ balance-sheet variables. Moreover, CDS spreads matter more than equity valuations.

We empirically study the nature of rollover risk and show how banks manage it. Having to roll over debt does not lead to higher default risk per se. Only banks that lose significant access to new funding while having to roll over debt display higher default risk. We identify a factor that determines this buildup of risk: specifically, debt maturity shortening (forcing debt to be more frequently rolled over) and reduced access to new funding are both driven by market pessimism about banks’ future performance. We also provide evidence consistent with dynamic coordination risk.

We empirically show the dynamics of information production and information sensitivity of bank debt around the Great Recession. As more precise information is produced at the onset of the crisis, bank debt becomes informationally sensitive, along two separate dimensions. First, precise information amplifies the effect of market expectations on default risk; second, for banks that are already expected to perform poorly, more precise information further increases default risk. Both effects are muted in good times.