DP14427 Twin Default Crises

Author(s): Caterina Mendicino, Kalin Nikolov, Juan Francisco Rubio-Ramírez, Javier Suarez, Dominik Supera
Publication Date: February 2020
Date Revised: March 2020
Keyword(s): Bank Fragility, Capital requirements, Default Risk, loan returns, non-diversifiable risk
JEL(s): E3, E44, G01, G21
Programme Areas: Financial Economics, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14427

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.