We investigate the effect of sovereign risk on banks' credit provision. We use the August 1999 Marmara Earthquake as an unanticipated exogenous fiscal shock that led to an increase in Turkish government's default risk. Based on administrative data on the universe of banks, we find that banks with higher exposures to government bonds before the earthquake suffered a bigger shock to their balance sheet and decreased lending more than the banks with lower exposures, after the earthquake. A bank that holds half of its total assets in government bonds decreases lending to private sector, measured as private sector loans to asset ratio, 2.5 percentage points. We show a similar effect on foreign banks' lending outside Turkey, where these banks also had high exposure to Turkish government bonds pre-earthquake, easing concerns on earthquake driven changes in credit demand. Our estimates, which trace the impact of an exogenous 100 basis point increase in sovereign spreads due to earthquake to credit supply by banks, explain 55 percent of the actual decline in loan provision during July-October 1999. These findings show that bank-sovereign doom loop can be responsible for a large fraction of credit crunch during an actual sovereign debt crisis.
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