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Sovereign Default Risk and Bank Balance Sheets

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  • Pablo D'Erasmo

    (University of Maryland)

  • Bora Durdu

    (Federal Reserve Board)

  • Emine Boz

    (International Monetary Fund)

Abstract

This paper explores how banks' balance sheets and sovereign risk affect macroeconomic fluctuations jointly. The heightened sovereign risk and a potential default constrain the banks' ability to extend credit to firms. This happens through the capital requirement that limits the size of the bank loans to firms and government to a fraction of the banks' equity. An increase in non-performing loans to firms also hampers the bank balance sheets. With the joint interaction of sovereign risk and bank balance sheets in place, the paper, first, shows the bank balance sheet stresses and the government's need for funds to provide deposit insurance can trigger a sovereign default. The paper then examines how the introduction of specific risk weights for certain assets affect macroeconomic fluctuations and, more importantly, the joint determination of sovereign debt and banking crises.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2013 Meeting Papers with number 1045.

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Date of creation: 2013
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Handle: RePEc:red:sed013:1045

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Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
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  1. Skander Van den Heuvel, 2005. "The Welfare Cost of Bank Capital Requirements," 2005 Meeting Papers 880, Society for Economic Dynamics.
  2. Carmen M. Reinhart & Kenneth S. Rogoff, 2010. "From Financial Crash to Debt Crisis," NBER Working Papers 15795, National Bureau of Economic Research, Inc.
  3. Kishan, Ruby P & Opiela, Timothy P, 2000. "Bank Size, Bank Capital, and the Bank Lending Channel," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(1), pages 121-41, February.
  4. Enrique G. Mandoza & Vivian Z. Yue, 2008. "A solution to the default risk-business cycle disconnect," International Finance Discussion Papers 924, Board of Governors of the Federal Reserve System (U.S.).
  5. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
  6. Cristina Arellano, 2008. "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, American Economic Association, vol. 98(3), pages 690-712, June.
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