Sovereign defaults and banking crises

Abstract

Episodes of sovereign default feature three key empirical regularities in connection with the banking systems of the countries where they occur: (i) sovereign defaults and banking crises tend to happen together, (ii) commercial banks have substantial holdings of government debt, and (iii) sovereign defaults result in major contractions in bank credit and production. This paper provides a rationale for these phenomena by extending the traditional sovereign default framework to incorporate bankers who lend to both the government and the corporate sector. When these bankers are highly exposed to government debt, a default triggers a banking crisis, which leads to a corporate credit collapse and subsequently to an output decline. When calibrated to the 2001-02 Argentine default episode, the model is able to produce default in equilibrium at observed frequencies, and when defaults occur credit contracts sharply, generating output drops of 7 percentage points, on average. Moreover, the model matches several moments of the data on macroeconomic aggregates, sovereign borrowing, and fiscal policy. The framework presented can also be useful for studying the optimality of fractional defaults. JEL codes: F34, E62

Sovereign Default and Monetary Policy Tradeoffs

“…There are strong theoretical and empirical reasons to expect causal links between sovereign default and the fragility of the banking system. For instance, Sosa-Padilla (2015) argues that the main costs of sovereign default arise from the impact on the balance sheets of banks holding that debt, as they sharply contract corporate lending leading, while Brunnermeier et al (2016) suggest that there may be a "diabolic loop" linking soveriegn and bank credit risk. Such links can motivate why the central bank chooses to accommodate sovereign risk.…”

History Remembered: Optimal Sovereign Default on Domestic and External Debt

“…The key difference relative to our setup is that these studies assume a representative agent and do not focus on default on domestic debt-holders. Other studies in this literature related to our work include those focusing on the effects of default on domestic agents, foreign and domestic lenders, optimal taxation, the role of secondary markets, discriminatory versus nondiscriminatory default and bailouts (e.g., Guembel and Sussman [30]; Broner et al [15]; Gennaioli et al [29]; Aguiar and Amador [1]; Mengus [42]; Di Casola and Sichlimiris [23]; Perez [46]; Bocola [14]; Sosa-Padilla [50]; and Paczos and Shakhnov [44]). As in some of these studies, default in our setup is nondiscriminatory, but in general, these studies abstract from distributional default incentives and social benefits of debt for self-insurance, liquidity and risk-sharing.…”

Collateral, Liquidity and Debt Sustainability

“…Strategic default on domestic government debt has recently been studied by D’Erasmo and Mendoza (), Juessen and Schabert (), Sosa‐Padilla () and Pouzo (). However, different from our article, D’Erasmo and Mendoza () focus on redistributive implications.…”

“…Juessen and Schabert () consider a setup with risk‐neutral agents and exogenous default costs. Similar to our approach, Sosa‐Padilla () invokes a working capital constraint to generate endogenous default costs but the government's default decision is binary and debt is again priced by risk‐neutral agents. Pouzo () proceeds under the assumption that the government can commit to its tax policy but not to the repayment of outstanding debt; different from our model, default triggers a temporary breakdown of the primary bond market but debt continues to be traded on secondary markets and hence retains a positive valuation in anticipation of a future recovery of the primary market.…”