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Sovereign Defaults and Banking Crises

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  • Cesar Sosa-Padilla

Abstract

Episodes of sovereign default feature three key empirical regularities in connection with the banking systems of the countries where they occur: (i) sovereign defaults and banking crises tend to happen together, (ii) commercial banks have substantial holdings of government debt, and (iii) sovereign defaults result in major contractions in bank credit and production. This paper provides a rationale for these phenomena by extending the traditional sovereign default framework to incorporate bankers who lend to both the government and the corporate sector. When these bankers are highly exposed to government debt, a default triggers a banking crisis, which leads to a corporate credit collapse and subsequently to an output decline. When calibrated to the 2001-02 Argentine default episode, the model is able to produce default in equilibrium at observed frequencies, and when defaults occur credit contracts sharply, generating output drops of 6% below trend, on average. Moreover, the model matches several moments of the data on macroeconomic aggregates, sovereign borrowing, and scal policy. The framework presented can also be useful for studying the optimality of fractional defaults and the political economy of domestic debt repudiation.

Suggested Citation

  • Cesar Sosa-Padilla, 2012. "Sovereign Defaults and Banking Crises," Department of Economics Working Papers 2012-09, McMaster University, revised Aug 2015.
  • Handle: RePEc:mcm:deptwp:2012-09
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    More about this item

    Keywords

    sovereign default; banking crisis; credit crunch; optimal fiscal policy; Markov perfect equilibrium; endogenous cost of default; domestic debt.;

    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy

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