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Financial Stability with Sovereign Debt

Author

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  • Ryuichiro Izumi

    () (Department of Economics, Wesleyan University)

Abstract

Are government guarantees or fnancial regulation a more effective way to prevent banking crises? I study this question in the presence of a negative feedback loop between the fscal position of the government and the health of the banking sector. I construct a model of fnancial intermediation in which the government issues, and may default on, debt. Banks hold some of this debt, which ties their health to that of the government. The government's tax revenue, in turn, depends on the quantity of investment that banks are able to fnance. I compare the effectiveness of government guarantees, liquidity regulation, and a combination of these policies in preventing self-fulflling bank runs. In some cases, a combination of the two policies is needed to prevent a run. In other cases, liquidity regulation alone is effective and adding guarantees would make the fnancial system fragile.

Suggested Citation

  • Ryuichiro Izumi, 2020. "Financial Stability with Sovereign Debt," Wesleyan Economics Working Papers 2020-001, Wesleyan University, Department of Economics.
  • Handle: RePEc:wes:weswpa:2020-001
    as

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    File URL: http://repec.wesleyan.edu/pdf/rizumi/2020001_izumi.pdf
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    References listed on IDEAS

    as
    1. Viral V. Acharya & Raghuram G. Rajan, 2013. "Sovereign Debt, Government Myopia, and the Financial Sector," Review of Financial Studies, Society for Financial Studies, vol. 26(6), pages 1526-1560.
    2. Russell Cooper & Kalin Nikolov, 2018. "Government Debt And Banking Fragility: The Spreading Of Strategic Uncertainty," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 59(4), pages 1905-1925, November.
    3. 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.
    4. Viral Acharya & Itamar Drechsler & Philipp Schnabl, 2014. "A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk," Journal of Finance, American Finance Association, vol. 69(6), pages 2689-2739, December.
    5. Chang, Roberto & Velasco, Andres, 2000. "Financial Fragility and the Exchange Rate Regime," Journal of Economic Theory, Elsevier, vol. 92(1), pages 1-34, May.
    6. Cooper, Russell & Ross, Thomas W., 1998. "Bank runs: Liquidity costs and investment distortions," Journal of Monetary Economics, Elsevier, vol. 41(1), pages 27-38, February.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Bank runs; Sovereign default; Feedback loop; Government guarantees; Liquidity regulation;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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