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Modeling Guarantees, Over-Indebtedness and Financial Crises in an Open Economy

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  • Germana Corrado

Abstract

This work develops a simple framework to analyse how financial intermediaries' balance sheet problems combined with financial guarantees make an economy more vulnerable to financial crises. A 'double default' problem - that is, the default of financial intermediaries on their debt repayments and of the government on its guarantees to bailout intermediaries' losses - is modelled in this study. The possibility of multiple equilibria, including a crisis equilibrium where the government is not able or willing to honor its guarantees towards the domestic financial sector, arises from the interplay of all the above elements: financial intermediaries' level of indebtedness, government implicit guarantees and high-risk creditors' lending. This work also produces predictions concerning the vulnerability to a financial crisis: multiple equilibria are possible only in certain ranges of the fundamentals.

Suggested Citation

  • Germana Corrado, 2011. "Modeling Guarantees, Over-Indebtedness and Financial Crises in an Open Economy," International Economic Journal, Taylor & Francis Journals, vol. 25(1), pages 147-172.
    • Handle: RePEc:taf:intecj:v:25:y:2011:i:1:p:147-172
    DOI: 10.1080/10168737.2010.487542
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