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Discussion Paper Details

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Title: Twin Default Crises

Author(s): Caterina Mendicino, Kalin Nikolov, Juan Francisco Rubio-Ramírez, Javier Suarez and Dominik Supera

Publication Date: February 2020

Keyword(s): Bank Fragility, Capital requirements, Default Risk, loan returns and non-diversifiable risk

Programme Area(s): Financial Economics and Monetary Economics and Fluctuations

Abstract: We study the interaction between borrowers' and banks' solvency in a quantitative macroeconomic model with financial frictions in which bank assets are a portfolio of defaultable loans. We show that ex-ante imperfect diversification of bank lending generates bank asset returns with limited upside but significant downside risk. The asymmetric distribution of these returns and their implications for the evolution of bank net worth are important for capturing the frequency and severity of twin default crises -simultaneous rises in firm and bank defaults associated with sizeable negative effects on economic activity. As a result, our model implies higher optimal capital requirements than common specifications of bank asset returns, which neglect or underestimate the impact of borrower default on bank solvency.

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Bibliographic Reference

Mendicino, C, Nikolov, K, Rubio-Ramírez, J, Suarez, J and Supera, D. 2020. 'Twin Default Crises'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=14427