Using structural vector autoregression augmented with stochastic volatility (SVAR-SV), we document that in late 2000s there were large spikes in volatility of spreads on peripheral eurozone government bonds. This increased volatility entailed a significant decline in bank credit to nonfinancial sector and real economic activity. We rationalize these results in a New Keynesian dynamic stochastic general equilibrium (DSGE) model with financial intermediation. In our framework, a rise in spread volatility erodes banks’ net worth and constrains their balance sheets. The banks respond by slashing their lending to real sector, dampening the economy as a whole. Results from the model match our empirical findings.
 

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