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Sovereign Default Risk and Bank Fragility in Financially Integrated Economies

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  • Bolton, Patrick
  • Jeanne, Olivier

Abstract

We analyze contagious sovereign debt crises in financially integrated economies. Under financial integration banks optimally diversify their holdings of sovereign debt in an effort to minimize the costs with respect to an individual country's sovereign debt default. While diversification generates risk diversification benefits ex ante, it also generates contagion ex post. We show that financial integration without fiscal integration results in an inefficient equilibrium supply of government debt. The safest governments inefficiently restrict the amount of high quality debt that could be used as collateral in the financial system and the riskiest governments issue too much debt, as they do not take account of the costs of contagion. Those inefficiencies can be removed by various forms of fiscal integration, but fiscal integration typically reduce the welfare of the country that provides the "safe-haven" asset below the autarky level.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8358.

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Date of creation: Apr 2011
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Handle: RePEc:cpr:ceprdp:8358

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Keywords: banking; collateral; European debt crisis; European Monetary Union; financial contagion; government debt; government default; international financial integration;

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References

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  1. Fernando A Broner & Alberto Martin & Jaume Ventura, 2006. "Sovereign Risk and Secondary Markets," Working Papers 306, Barcelona Graduate School of Economics.
  2. Gennaioli, Nicola & Martin, Alberto & Rossi, Stefano, 2010. "Sovereign Default, Domestic Banks and Financial Institutions," CEPR Discussion Papers 7955, C.E.P.R. Discussion Papers.
  3. repec:bla:restud:v:76:y:2009:i:3:p:879-902 is not listed on IDEAS
  4. Patrick Bolton & Olivier Jeanne, 2007. "Structuring and Restructuring Sovereign Debt: The Role of a Bankruptcy Regime," Journal of Political Economy, University of Chicago Press, vol. 115(6), pages 901-924, December.
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Citations

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Cited by:
  1. Georg Erber, 2012. "Eurobonds und Transferleistungen innerhalb der Eurozone," Ifo Schnelldienst, Ifo Institute for Economic Research at the University of Munich, vol. 65(01), pages 14-19, 01.
  2. Marta Gómez-Puig & Simón Sosvilla-Rivero, 2011. "Causality and contagion in peripheral EMU public debt markets: a dynamic approach," IREA Working Papers 201116, University of Barcelona, Research Institute of Applied Economics, revised Sep 2011.
  3. Ricardo Correa & Kuan-Hui Lee & Horacio Sapriza & Gustavo Suarez, 2012. "Sovereign credit risk, banks' government support, and bank stock returns around the world," International Finance Discussion Papers 1069, Board of Governors of the Federal Reserve System (U.S.).
  4. Panetta, Fabio & Correa, Ricardo & Davies, Michael & Di Cesare, Antonio & Marques, José-Manuel & Nadal de Simone, Francisco & Signoretti, Federico & Vespro, Cristina & Vildo, Siret & Wieland, Martin , 2011. "The impact of sovereign credit risk on bank funding conditions," MPRA Paper 32581, University Library of Munich, Germany.
  5. Benjamin Käfer & Jochen Michaelis, 2012. "Länderrisiko: Die ökonomischen Konsequenzen einer Herabstufung durch die Rating-Agenturen," MAGKS Papers on Economics 201202, Philipps-Universität Marburg, Faculty of Business Administration and Economics, Department of Economics (Volkswirtschaftliche Abteilung).
  6. Markus K. Brunnermeier & Martin Oehmke, 2012. "Bubbles, Financial Crises, and Systemic Risk," NBER Working Papers 18398, National Bureau of Economic Research, Inc.
  7. Carolina Achury & Christos Koulovatianos & John D. Tsoukalas, 2011. "External Sovereign Debt in a Monetary Union: Bailouts and the Role of Corruption," CESifo Working Paper Series 3532, CESifo Group Munich.
  8. Canofari Paolo & Di Bartolomeo Giovanni & Piersanti Giovanni, 2013. "Theory and practice of contagion in monetary unions. Domino effects in EU Mediterranean countries: The case of Greece, Italy and Spain," wp.comunite 0098, Department of Communication, University of Teramo.
  9. Michael Davies & Tim Ng, 2011. "The rise of sovereign credit risk: implications for financial stability," BIS Quarterly Review, Bank for International Settlements, September.
  10. Bicu Andreea & Candelon Bertrand, 2012. "On the importance of indirect banking vulnerabilities in the Eurozone," Research Memoranda 033, Maastricht : METEOR, Maastricht Research School of Economics of Technology and Organization.

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