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Twin Default Crises

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We study the interaction between borrowers' and banks' solvency in a quantitative macroeconomic model with financial frictions in which bank assets are a portfolio of defaultable loans. We show that ex-ante imperfect diversification of bank lending generates bank asset returns with limited upside but significant downside risk. The asymmetric distribution of these returns and their implications for the evolution of bank net worth are important for capturing the frequency and severity of twin default crises - simultaneous rises in firm and bank defaults associated with sizeable negative effects on economic activity. As a result, our model implies higher optimal capital requirements than common specifications of bank asset returns, which neglect or underestimate the impact of borrower default on bank solvency.

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  • Caterina Mendicino & Kalin Nikolov & Juan Rubio-Ramirez & Javier Suarez & Dominik Supera, 2020. "Twin Default Crises," Working Papers wp2020_2006, CEMFI.
    • Handle: RePEc:cmf:wpaper:wp2020_2006
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    Cited by:

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    2. Sigurd Galaasen & Rustam Jamilov & Hélène Rey & Ragnar Juelsrud, 2020. "Granular credit risk," Working Paper 2020/15, Norges Bank.
    3. Reiter, Michael & Zessner-Spitzenberg, Leopold, 2023. "Long-term bank lending and the transfer of aggregate risk," Journal of Economic Dynamics and Control, Elsevier, vol. 151(C).
    4. Mendicino, Caterina & Nikolov, Kalin & Ramirez, Juan-Rubio & Suarez, Javier & Supera, Dominik, 2021. "How much capital should banks hold?," Research Bulletin, European Central Bank, vol. 80.

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    More about this item

    Keywords

    Bank default; firm default; financial crises; bank capital requirements.;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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