Diego Friedheim - Lenders' Expectations and Sovereign Debt Crises Contagion
Abstract: This paper investigates the role of lenders' expectations in propagating the European sovereign debt crisis within the Eurozone periphery. It documents that banks that made less precise forecasts before the crisis, after an increase in Greek sovereign yield, increased (reduced) their sovereign bond yield (GDP) forecasts for other Eurozone periphery countries more than the more precise banks. During the crisis, the former also reduced their Eurozone periphery debt holdings more than the latter. A potential explanation is that less precise banks (over) extrapolate news from one country in the region to other countries in the same area. The empirical evidence favors this hypothesis. This paper provides an endogenous sovereign default model to quantify the effect of having less precise lenders on countries' default probabilities.
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