Co‐ordination Failure, Moral Hazard and Sovereign Bankruptcy Procedures

Abstract

We study a model of sovereign debt crisis that combines problems of creditor co-ordination and debtor moral hazard. In the face of sovereign default, the need to give appropriate incentives to the debtor leads to excessive 'rollover failure' by creditors. We discuss how the incidence of crises might be reduced by international sovereign bankruptcy proceduresinvolving increased 'contractibility' of sovereign debtor's payoffs, suspension of convertibility in a 'discovery' phase and penalties in case of malfeasance. In relation to the current debate, this is more akin to the IMF's Sovereign Debt Restructuring Mechanism than the Collective Action Clauses promoted by others.

Hares and stags in Argentinean debt restructuring

“…23 The condition Ω N ω indicates that the debtor country's ability to pay is higher than her willingness. This assumption is consistent with most of the academic literature on this topic (Haldane et al, 2005;Ghosal and Miller, 2003). In these models the underlying rationale relates to a moral hazard situation regarding the debtor's incentives for compliance.…”

“…As this sub-game can be interpreted as part of a larger zero-sum restructuring game played by the debtor and the whole creditor community we disregard aspects of welfare analysis. That creditor coordination can result in a stag-hunt game has already been shown by Ghosal and Miller (2003). These authors analyze the coordination failures in the context of a rollover-decision by creditors triggering a liquidity shortage.…”

“…Observe that this solution is identical to the one obtained in the 2-player case. For a more formal derivation of the symmetric mixed strategy equilibrium, and also for cases with collective action clauses, see Ghosal and Miller (2003).…”

Hostages, free lunches and institutional gaps: the case of the European Currency Union

“…The signal content is reduced. Even worse, there are likely multiple equilibriums in the game between lenders and distressed states rendering the interpretation of market signals more doubtful (Ghosal and Miller 2003).…”

“…To achieve these objectives, a European Insolvency Charter should address not only distressed member states, but, equally important, EU-politics. Ghosal and Miller (2003) argue in general that "in the absence of bankruptcy style procedures, there will almost always be excessive disorderly default in sovereign bond markets".…”