Financial Fragility, Sovereign Default Risk and the Limits to Commercial Bank Bail-outs
AbstractWe analyse the poisonous interaction between bank rescues, financial fragility and sovereign debt discounts. In our model balance sheet constrained financial intermediaries finance both capital expenditure of intermediate goods producers and government deficits. The financial intermediaries face the risk of a (partial) default of the government on its debt obligations. We analyse the impact of a financial crisis, first under full government credibility and then with an endogenous sovereign debt discount. We introduce long term government debt, which gives rise to the possibility of capital losses on bank balance sheets. The negative feedback effects from falling bond prices on the economy are shown to increase with the average duration of the government bonds, as higher interest rates on new debt lead to capital losses on banks' holding of existing long term (government) debt. The associated increase in credit tightness leads to a negative amplification effect, significantly increasing output losses and declines in investment after a financial crisis. We introduce sovereign default risk through the existence of a maximum sustainable level of debt, derived from the maximum level of taxation that is politically feasible. When close to this limit, sovereign discounts emerge reflecting potential defaults on debt, creating a strong link between sovereign default risk and financial fragility emerges. A debt-financed recapitalisation of the financial intermediaries causes bond prices to drop triggering capital losses at the bank under intervention. This mechanism shows the limits to conventional bank bail-outs in countries with fragile public creditworthiness, limits that became very visible during the Great Recession in Southern Europe.
Download InfoTo our knowledge, this item is not available for download. To find whether it is available, there are three options:
1. Check below under "Related research" whether another version of this item is available online.
2. Check on the provider's web page whether it is in fact available.
3. Perform a search for a similarly titled item that would be available.
Bibliographic InfoPaper provided by Tinbergen Institute in its series Tinbergen Institute Discussion Papers with number 13-179/IV/DSF65.
Date of creation: 25 Oct 2013
Date of revision:
Contact details of provider:
Web page: http://www.tinbergen.nl
Financial Intermediation; Macrofinancial Fragility; Fiscal Policy; Sovereign Default Risk;
Find related papers by JEL classification:
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
- H30 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - General
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Cristina Arellano & Ananth Ramanarayanan, 2008.
"Default and the maturity structure in sovereign bonds,"
410, Federal Reserve Bank of Minneapolis.
- Cristina Arellano & Ananth Ramanarayanan, 2012. "Default and the Maturity Structure in Sovereign Bonds," Journal of Political Economy, University of Chicago Press, vol. 120(2), pages 187 - 232.
- Cristina Arellano & Ananth Ramanarayanan, 2008. "Default and the maturity structure in sovereign bonds," Globalization and Monetary Policy Institute Working Paper 19, Federal Reserve Bank of Dallas.
- Ananth Ramanarayanan & Cristina Arellano, 2008. "Default and the Maturity Structure in Sovereign Bonds," 2008 Meeting Papers 479, Society for Economic Dynamics.
- Martin Uribe, 2002.
"A Fiscal Theory of Sovereign Risk,"
NBER Working Papers
9221, National Bureau of Economic Research, Inc.
- Cristina Arellano, 2008.
"Default Risk and Income Fluctuations in Emerging Economies,"
American Economic Review,
American Economic Association, vol. 98(3), pages 690-712, June.
- Arellano, Cristina, 2008. "Default risk and income fluctuations in emerging economies," MPRA Paper 7867, University Library of Munich, Germany.
- Woodford, Michael, 2001.
"Fiscal Requirements for Price Stability,"
Journal of Money, Credit and Banking,
Blackwell Publishing, vol. 33(3), pages 669-728, August.
- Burcu Eyigungor & Satyajit Chatterjee, 2008.
"Maturity, Indebtedness and Default Risk,"
2008 Meeting Papers
1001, Society for Economic Dynamics.
- Satyajit Chatterjee & Burcu Eyigungor, 2009. "Maturity, indebtedness, and default risk," Working Papers 09-2, Federal Reserve Bank of Philadelphia.
- Satyajit Chatterjee & Burcu Eyigungor, 2009. "Maturity, Indebtedness, and Default Risk," KoÃ§ University-TUSIAD Economic Research Forum Working Papers 0901, Koc University-TUSIAD Economic Research Forum.
- Satyajit Chatterjee & Burcu Eyigungor, 2011. "Maturity, indebtedness, and default risk," Working Papers 11-33, Federal Reserve Bank of Philadelphia.
- Satyajit Chatterjee & Burcu Eyigungor, 2010. "Maturity, indebtedness, and default risk," Working Papers 10-12, Federal Reserve Bank of Philadelphia.
- Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
- Claessens, Stijn & van Wijnbergen, Sweder, 1993. "Secondary Market Prices and Mexico's Brady Deal," The Quarterly Journal of Economics, MIT Press, vol. 108(4), pages 967-82, November.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Antoine Maartens (+31 626 - 160 892)).
If references are entirely missing, you can add them using this form.