DP7955 Sovereign Default, Domestic Banks and Financial Institutions

Author(s): Nicola Gennaioli, Alberto Martín, Stefano Rossi
Publication Date: August 2010
Keyword(s): Capital Flows, Financial Liberalization, Institutions, Sovereign Risk, Sudden Stops
JEL(s): F34, F36, G15, H63
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7955

We build a model where sovereign defaults weaken banks? balance sheets because banks hold sovereign bonds, causing private credit to decline. Stronger financial institutions boost default costs by amplifying these balance-sheet effects. This yields a novel complementarity between public debt and domestic credit markets, where the latter sustain the former by increasing the costs of default. We document three novel empirical facts that are consistent with our model's predictions: public defaults are followed by large private credit contractions; these contractions are stronger in countries where banks hold more public debt and financial institutions are stronger; in these same countries default is less likely.