Sovereign debt markets in a monetary union are argued to be vulnerable to self-fulfilling dynamics that can trigger default even in the absence of a major change in macro fundamentals, in which case a lender of last resort (LOLR) could solve the coordination problems and stop the panic among investors. We provide clear evidence on this by using the setting of Eurozone crises and a policy shock by the ECB in which it surprised the markets by openly declaring its LOLR position. Using a synthetic control method to create a counterfactual scenario for each country, we find that the policy had a causal impact in stopping the time-varying shocks that previously discriminated against Eurozone countries. We illustrate that these shocks were not only significant for the usual suspects such as Ireland and Spain; but also for the core Euro countries, such as Austria and Belgium. We also investigate the implications of these shocks for the sovereign debt exposures of the European banks.
Orkun Saka is an Assistant Professor of Finance at the University of Sussex and a Research Associate at the Systemic Risk Centre and European Institute of the London School of Economics and Political Science (LSE). He is passionate about research on financial crises and political economy of financial intermediation. He tweets @orknsk.