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Sovereign Default Risk and Bank Fragility in Financially Integrated Economies

  • Patrick Bolton
  • Olivier Jeanne

We analyze contagious sovereign debt crises in financially integrated economies. Under financial integration banks optimally diversify their holdings of sovereign debt in an effort to minimize the costs with respect to an individual country's sovereign debt default. While diversification generates risk diversification benefits ex ante, it also generates contagion ex post. We show that financial integration without fiscal integration results in an inefficient equilibrium supply of government debt. The safest governments inefficiently restrict the amount of high quality debt that could be used as collateral in the financial system and the riskiest governments issue too much debt, as they do not take account of the costs of contagion. Those inefficiencies can be removed by various forms of fiscal integration, but fiscal integration typically reduce the welfare of the country that provides the "safe-haven" asset below the autarky level.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16899.

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Date of creation: Mar 2011
Date of revision:
Publication status: published as 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.
Handle: RePEc:nbr:nberwo:16899
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  1. Adrian Blundell-Wignall & Patrick Slovik, 2010. "The EU Stress Test and Sovereign Debt Exposures," OECD Working Papers on Finance, Insurance and Private Pensions 4, OECD Publishing.
  2. 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.
  3. Fernando A. Broner & Alberto Martín & Jaume Ventura, 2015. "Sovereign Risk and Secondary Markets," Working Papers 288, Barcelona Graduate School of Economics.
  4. Reinhart, Carmen, 2009. "The Second Great Contraction," MPRA Paper 21485, University Library of Munich, Germany.
  5. Bolton, Patrick & Roland, Gerard, 1996. "Distributional Conflicts, Factor Mobility, and Political Integration," American Economic Review, American Economic Association, vol. 86(2), pages 99-104, May.
  6. Broner, Fernando A & Ventura, Jaume, 2006. "Globalization and Risk Sharing," CEPR Discussion Papers 5820, C.E.P.R. Discussion Papers.
  7. Patrick Bolton & Olivier Jeanne, 2007. "Structuring and Restructuring Sovereign Debt: The Role of a Bankruptcy Regime," Journal of Political Economy, University of Chicago Press, vol. 115(6), pages 901-924, December.
  8. Nicola Gennaioli & Alberto Martin & Stefano Rossi, 2009. "Sovereign default, domestic banks and financial institutions," Economics Working Papers 1170, Department of Economics and Business, Universitat Pompeu Fabra, revised Feb 2012.
  9. De Santis, Roberto A. & Gérard, Bruno, 2006. "Financial integration, international portfolio choice and the European Monetary Union," Working Paper Series 0626, European Central Bank.
  10. Guido Sandleris, 2010. "Sovereign Defaults, Domestic Credit Market Institutions and Credit to the Private Sector," Business School Working Papers 2010-01, Universidad Torcuato Di Tella.
  11. Michael Kumhof & Evan Tanner, 2005. "Government Debt: A Key Role in Financial Intermediation," IMF Working Papers 05/57, International Monetary Fund.
  12. Thomas Philippon, 2010. "Debt Overhang and Recapitalization in Closed and Open Economies," IMF Economic Review, Palgrave Macmillan, vol. 58(1), pages 157-178, August.
  13. Bolton, Patrick & Roland, Gerard, 1997. "The Breakup of Nations: A Political Economy Analysis," The Quarterly Journal of Economics, MIT Press, vol. 112(4), pages 1057-90, November.
  14. Patrick Bolton & Olivier Jeanne, 2009. "Structuring and Restructuring Sovereign Debt: The Role of Seniority -super-1," Review of Economic Studies, Oxford University Press, vol. 76(3), pages 879-902.
  15. Alberto Alesina & Enrico Spolaore, 1995. "On the Number and Size of Nations," NBER Working Papers 5050, National Bureau of Economic Research, Inc.
  16. Reinhart, Carmen & Rogoff, Kenneth, 2009. "This Time It’s Different: Eight Centuries of Financial Folly-Preface," MPRA Paper 17451, University Library of Munich, Germany.
  17. Reinhart, Carmen & Vegh, Carlos & Velasco, Andres, 2008. "Money, Crises, and Transition Essays in Honor of Guillermo A. Calvo: An Introduction," MPRA Paper 13232, University Library of Munich, Germany.
  18. Edda Zoli & Silvia Sgherri, 2009. "Euro Area Sovereign Risk During the Crisis," IMF Working Papers 09/222, International Monetary Fund.
  19. Ejsing, Jacob & Lemke, Wolfgang, 2009. "The Janus-headed salvation: sovereign and bank credit risk premia during 2008-09," Working Paper Series 1127, European Central Bank.
  20. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, June.
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