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Banking and Sovereign Debt Crises in Monetary Union Without Central Bank Intervention

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  • Jin Cheng
  • Meixing Dai
  • Frédéric Dufourt

Abstract

We propose a model to analyze the conditions of emergence of a twin banking and sovereign debt crisis in a monetary union with an institutional framework which is broadly similar to the Eurozone at the onset of the financial crisis. We show that when the responsibility of rescuing the banking system is entirely ascribed to domestic governments - in particular because the central bank is not allowed to intervene as a lender of last resort on sovereign bond markets - the main tool to fight against a systemic banking crisis (the financial safety net) may aggravate, instead of mitigate, the solvency problems of banks and of the government. Depending on investors' expectations, the banking system and the government may either survive a negative financial shock or fail together. In this context of negative self-fulfilling expectations, we also analyze the role of credit rating agencies as potential catalysts to the crisis, we emphasize possible contagion effects to "healthy" member states through the banking system, and we discuss proposed policy options like the creation of "Eurobonds" to avoid the resurgence of such crises.

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Bibliographic Info

Paper provided by Bureau d'Economie Théorique et Appliquée, UDS, Strasbourg in its series Working Papers of BETA with number 2014-05.

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Date of creation: 2014
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Handle: RePEc:ulp:sbbeta:2014-05

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Keywords: banking crisis; sovereign debt crisis; bank runs; financial safety net; liquidity regulation; government deposit guaranteen self fulfilling propheties.;

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  1. Alejandro Justiniano & Bruce Preston, 2009. "Monetary policy and uncertainty in an empirical small open economy model," Working Paper Series WP-09-21, Federal Reserve Bank of Chicago.
  2. Patrick Bolton & Olivier Jeanne, 2011. "Sovereign Default Risk and Bank Fragility in Financially Integrated Economies," IMF Economic Review, Palgrave Macmillan, vol. 59(2), pages 162-194, June.
  3. Javier Garcia-Cicco & Roberto Pancrazi & Martin Uribe, 2010. "Real Business Cycles in Emerging Countries?," American Economic Review, American Economic Association, vol. 100(5), pages 2510-31, December.
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  5. De Grauwe, Paul & Ji, Yuemei, 2013. "Self-fulfilling crises in the Eurozone: An empirical test," Journal of International Money and Finance, Elsevier, vol. 34(C), pages 15-36.
  6. 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.
  7. Philip R. Lane, 2012. "The European Sovereign Debt Crisis," Journal of Economic Perspectives, American Economic Association, vol. 26(3), pages 49-68, Summer.
  8. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Closing Small Open Economy Models," NBER Working Papers 9270, National Bureau of Economic Research, Inc.
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  10. Calvo, Guillermo A, 1988. "Servicing the Public Debt: The Role of Expectations," American Economic Review, American Economic Association, vol. 78(4), pages 647-61, September.
  11. Brutti, Filippo, 2011. "Sovereign defaults and liquidity crises," Journal of International Economics, Elsevier, vol. 84(1), pages 65-72, May.
  12. Eric M. Leeper, 2013. "Fiscal Limits and Monetary Policy," Central Bank Review, Research and Monetary Policy Department, Central Bank of the Republic of Turkey, vol. 13(2), pages 33-58.
  13. Viral V. Acharya & Itamar Drechsler & Philipp Schnabl, 2011. "A Pyrrhic Victory? - Bank Bailouts and Sovereign Credit Risk," NBER Working Papers 17136, National Bureau of Economic Research, Inc.
  14. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
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