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.