Bank Risk, Sovereign Default, and Financial Stability

Abstract

This article analyses the interconnections between bank risk and public finance. More precisely, it illustrates the mechanisms through which (i) credit risk of firms hits the banks’ balance sheets and (ii) spreads over to the public sector due to bailout costs and a reduced tax base triggered by lower households’ income and consumption. These events might (iii) force the sovereign into difficulties or even default and then (iii) feed back into the banks’ balance sheets through their government bond holdings. Such vicious loops meet the stylized facts of the current financial turmoil and the European debt and banking crisis. Apart from some recent contributions, theoretical economic research in this area has been scarce, however.