Abstract
Sovereign defaults feature three key empirical regularities regarding the domestic banking systems: (i) defaults and banking crises happen together, (ii) banks are largely exposed to government debt, (iii) defaults trigger major contractions in bank credit and production. We rationalize these phenomena by extending a traditional default framework to incorporate bankers who lend to both government and firms. When bankers are exposed to government debt, a default generates a banking crisis, which triggers collapses in corporate credit and output. Calibrated to the 2001-02 Argentine default, the model produces equilibrium crises at observed frequencies, sharp credit contractions, and output drops of 7%.
Highlights
Sovereign defaults and banking crises have been recurrent events in emerging economies
Recent default episodes in emerging economies (e.g., Russia 1998, Argentina 2001-02) have shown that whenever the sovereign decides to default on its debt there is an adverse impact on the domestic economy, largely through disruptions of the domestic financial systems
Based on three key empirical regularities, namely that (i) defaults and banking crises tend to happen together, (ii) banks are highly exposed to government debt, and (iii) crisis episodes are costly in terms of credit and output, we build a theoretical framework that links defaults, banking sector performance, and economic activity. This paper rationalizes these phenomena extending a traditional sovereign default framework to include bankers who lend to both the government and the corporate sector. When these bankers are highly exposed to government debt, a default triggers a banking crisis which leads to a corporate credit collapse and to an output decline
Summary
Sovereign defaults and banking crises have been recurrent events in emerging economies. Recent default episodes in emerging economies (e.g., Russia 1998, Argentina 2001-02) have shown that whenever the sovereign decides to default on its debt there is an adverse impact on the domestic economy, largely through disruptions of the domestic financial systems. Both in the Argentine and Russian cases (and in others discussed below), the banking sectors were highly exposed to government debt In this way a government default directly decreased the value of the banking sector’s assets. The concerns were about losing what had been invested in Greek bonds, and, and mostly, over how this shock to banks’ assets would impact their lending ability and the economic activity as a whole.
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