Credit supply and the rise in sovereign debt risk in the Eurozone

The aim of the paper is to establish whether, and to what extent, a rise in sovereign debt risk can cause a credit crunch. By conducting an empirical analysis of the eurozone countries for the period between the first quarter of 2010 and the last quarter of 2011, we first estimate the potential losses for banks on different kinds of financial assets by using credit default swap prices. Then, using a panel data estimate, we show that potential losses on government securities have a negative impact on credit supply, and that this impact is greater than that on other domestic or foreign assets. This evidence can be attributed to the role of government securities in banks' liquidity management. In the recent euro crisis the ECB has properly adopted measures aimed at relieving the lack of liquidity suffered by the banks of countries hit by a deterioration in their public debt worthiness.