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Banking and Sovereign Debt Crises in Monetary Union Without Central Bank Intervention

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  • Jin Cheng
  • Meixing Dai
  • Frédéric Dufourt

Abstract

We propose a model to analyze the conditions of emergence of a twin banking and sovereign debt crisis in a monetary union with an institutional framework which is broadly similar to the Eurozone at the onset of the financial crisis. We show that when the responsibility of rescuing the banking system is entirely ascribed to domestic governments - in particular because the central bank is not allowed to intervene as a lender of last resort on sovereign bond markets - the main tool to fight against a systemic banking crisis (the financial safety net) may aggravate, instead of mitigate, the solvency problems of banks and of the government. Depending on investors' expectations, the banking system and the government may either survive a negative financial shock or fail together. In this context of negative self-fulfilling expectations, we also analyze the role of credit rating agencies as potential catalysts to the crisis, we emphasize possible contagion effects to "healthy" member states through the banking system, and we discuss proposed policy options like the creation of "Eurobonds" to avoid the resurgence of such crises.

Suggested Citation

  • Jin Cheng & Meixing Dai & Frédéric Dufourt, 2014. "Banking and Sovereign Debt Crises in Monetary Union Without Central Bank Intervention," Working Papers of BETA 2014-05, Bureau d'Economie Théorique et Appliquée, UDS, Strasbourg.
  • Handle: RePEc:ulp:sbbeta:2014-05
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    References listed on IDEAS

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    Cited by:

    1. Jin Cheng & Meixing Dai & Frédéric Dufourt, 2015. "The banking crisis with interbank market freeze," Working Papers of BETA 2015-20, Bureau d'Economie Théorique et Appliquée, UDS, Strasbourg.

    More about this item

    Keywords

    banking crisis; sovereign debt crisis; bank runs; financial safety net; liquidity regulation; government deposit guaranteen self fulfilling propheties.;

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
    • G2 - Financial Economics - - Financial Institutions and Services

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