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Sovereign Default Risk and Bank Fragility in Financially Integrated Economies

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  • Patrick Bolton
  • Olivier Jeanne

Abstract

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.

Suggested Citation

  • Patrick Bolton & Olivier Jeanne, 2011. "Sovereign Default Risk and Bank Fragility in Financially Integrated Economies," NBER Working Papers 16899, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:16899
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    More about this item

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • F15 - International Economics - - Trade - - - Economic Integration
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • G01 - Financial Economics - - General - - - Financial Crises

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