By Cesar Sosa-Padilla
Episodes of sovereign default feature three key empirical regularities in connection with the banking systems of the countries where they occur: (i) sovereign defaults and banking crises tend to happen together, (ii) commercial banks have substantial holdings of government debt, and (iii) sovereign defaults result in major contractions in bank credit and production. This paper provides a rationale for these phenomena by extending the traditional sovereign default framework to incorporate bankers that 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 subsequently to an output decline. When calibrated to Argentina’s 2001 default episode the model produces default on equilibrium with a frequency in line with actual default frequencies, and when it happens credit experiences a sharp contraction which generates an output drop similar in magnitude to the one observed in the data. Moreover, the model also matches several moments of the cyclical dynamics of macroeconomic aggregates.
Interesting paper that deals with the joint crises of sovereign debt and the banking sector. While it focusses on Argentina, the perennial candidate for sovereign default, I wonder how much this paper also applies to the current situation in Europe. In this paper, banks decide to hold sovereign debt despite the demonstrated rsik of default. In Europe, banks are still holding sovereign debt after years of headlines about potential default, the only deifference being it has not happened (yet) except for a haircut in Greece.