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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
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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
Note: CF IFM PE
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  17. 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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  20. Thomas Philippon, 2010. "Debt Overhang and Recapitalization in Closed and Open Economies," IMF Economic Review, Palgrave Macmillan, vol. 58(1), pages 157-178, August.
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