Sovereign Default, Domestic Banks, and Financial Institutions

Abstract

We study the role of domestic financial institutions in sustaining capital flows to the private and public sector of a country whose government can default on its debt. As in recent public debt crises, in our model public defaults weaken banks' balance sheets, disrupting domestic financial markets. This effect leads to a novel complementarity between private capital inflows and public borrowing, where the former sustain the latter by boosting the government's cost of default. Our key message is that, by shaping the direction of private capital flows, financial institutions determine whether financial integration improves or reduces government discipline. We explore the implications of this complementarity for financial liberalization and debt-financed bailouts of banks. We present some evidence consistent with complementarity.JEL classification: F34, F36, G15, H63.

Cyprus: from boom to bail-in

“…Even if this is taken at face value, does it absolve the government from the responsibility of dealing with the crisis? Banking problems can affect the sovereign and vice versa (Gennaioli et al, 2014;Philippon and Schnabl (2013), Acharya et al, forthcoming) and the government should have been a lot more proactive in dealing with the problem.…”

Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty

“…This is the second key departure of our article from Gennaioli et al. (). In their model, a bailout is exogenous and has no implications for the value of government debt.…”

“…Gennaioli et al. () offer a more positive view of banks' government debt holdings. They show that banks' domestic debt exposures can serve as a government commitment device against strategic sovereign default.…”

“…In contrast, Gennaioli et al. () microfound output losses from sovereign default by assuming a timing where default occurs in the middle of the intermediation process, therefore disrupting it and causing a decline in investment and economic activity.…”

Were U.S. Banks Exposed to the Greek Debt Crisis? Evidence from Greek CDS Spreads

“…Gennaioli et al (2014) develop a model of sovereign debt in which government defaults are costly because they destroy the balance sheets of domestic banks. They find that government defaults lead to declines in private credit, and these declines are larger in countries where financial institutions are more developed and banks hold more government bonds.…”