The Vicious Circle of Banks' and Public Finances' Distress

Abstract

The recent financial crisis highlighted how the interconnection between banks and sovereign risk could translate a banking crisis into a sovereign crisis. Theoretical and empirical literature has examined both the transmission mechanisms between banks and sovereigns (and viceversa), looking also at how different types of crises occur and combine (the so-called 'twin crises' literature). Indeed, most papers exclusively focus on one channel of transmission, either quantifying the effects that banking crises have on public finances or analyzing when banking crises may cause sovereign debt crises (or viceversa). Still, the circular nature of the relationship between banking and sovereign debt crises has not been deeply addressed. In this paper a numerical approach is proposed to quantify the effects of this relationship and to highlight how sovereign and bank distresses may worsen each other because of their interconnection. We quantify the effects of banks' distress on the banking system itself, passing through the higher public deficit induced by State support, and a subsequent haircut in government bonds. The method is tested on four countries. Results show that, while limited crises tends to be absorbed by the system, serious crises tend to exacerbate at each turn, so that it's not possible to stop them without external interventions.