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Sovereign Default Risk and Bank Balance Sheets

  • Pablo D'Erasmo

    (University of Maryland)

  • Bora Durdu

    (Federal Reserve Board)

  • Emine Boz

    (International Monetary Fund)

This paper explores how banks' balance sheets and sovereign risk affect macroeconomic fluctuations jointly. The heightened sovereign risk and a potential default constrain the banks' ability to extend credit to firms. This happens through the capital requirement that limits the size of the bank loans to firms and government to a fraction of the banks' equity. An increase in non-performing loans to firms also hampers the bank balance sheets. With the joint interaction of sovereign risk and bank balance sheets in place, the paper, first, shows the bank balance sheet stresses and the government's need for funds to provide deposit insurance can trigger a sovereign default. The paper then examines how the introduction of specific risk weights for certain assets affect macroeconomic fluctuations and, more importantly, the joint determination of sovereign debt and banking crises.

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Paper provided by Society for Economic Dynamics in its series 2013 Meeting Papers with number 1045.

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Date of creation: 2013
Date of revision:
Handle: RePEc:red:sed013:1045
Contact details of provider: Postal: Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA
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  1. Carmen M. Reinhart & Kenneth S. Rogoff, 2011. "From Financial Crash to Debt Crisis," American Economic Review, American Economic Association, vol. 101(5), pages 1676-1706, August.
  2. 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.
  3. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
  4. Van den Heuvel, Skander J., 2008. "The welfare cost of bank capital requirements," Journal of Monetary Economics, Elsevier, vol. 55(2), pages 298-320, March.
  5. Enrique G. Mandoza & Vivian Z. Yue, 2008. "A solution to the default risk-business cycle disconnect," International Finance Discussion Papers 924, Board of Governors of the Federal Reserve System (U.S.).
  6. Cristina Arellano, 2008. "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, American Economic Association, vol. 98(3), pages 690-712, June.
  7. Kishan, Ruby P & Opiela, Timothy P, 2000. "Bank Size, Bank Capital, and the Bank Lending Channel," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(1), pages 121-41, February.
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