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Financial Fragility, Sovereign Default Risk and the Limits to Commercial Bank Bail-outs

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  • Sweder van Wijnbergen

    (University of Amsterdam)

  • Christiaan van der Kwaak

    (University of Amsterdam)

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    Abstract

    We 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.

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    Bibliographic Info

    Paper provided by Tinbergen Institute in its series Tinbergen Institute Discussion Papers with number 13-179/IV/DSF65.

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    Date of creation: 25 Oct 2013
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    Handle: RePEc:dgr:uvatin:20130179

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    Web page: http://www.tinbergen.nl

    Related research

    Keywords: Financial Intermediation; Macrofinancial Fragility; Fiscal Policy; Sovereign Default Risk;

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    References

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    1. Satyajit Chatterjee & Burcu Eyigungor, 2009. "Maturity, Indebtedness, and Default Risk," Koç University-TUSIAD Economic Research Forum Working Papers, Koc University-TUSIAD Economic Research Forum 0901, Koc University-TUSIAD Economic Research Forum.
    2. 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.
    3. Claessens, Stijn & van Wijnbergen, Sweder, 1993. "Secondary Market Prices and Mexico's Brady Deal," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 108(4), pages 967-82, November.
    4. Arellano, Cristina, 2008. "Default risk and income fluctuations in emerging economies," MPRA Paper 7867, University Library of Munich, Germany.
    5. Michael Woodford, 2001. "Fiscal Requirements for Price Stability," NBER Working Papers 8072, National Bureau of Economic Research, Inc.
    6. Uribe, Martín, 2002. "A fiscal theory of sovereign risk," Working Paper Series, European Central Bank 0187, European Central Bank.
    7. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, Elsevier, vol. 12(3), pages 383-398, September.
    8. Yun, Tack, 1996. "Nominal price rigidity, money supply endogeneity, and business cycles," Journal of Monetary Economics, Elsevier, Elsevier, vol. 37(2-3), pages 345-370, April.
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