Sovereign Default and Government's Bailouts
This paper studies the link between banking crises, sovereign default and government guarantees. A banking crisis can lead to a domestic credit crunch, which can be mitigated by government guarantees. However, the provision of bailout guaran- tees exposes the government to potentially severe losses from a banking sector failure and a sharp rise in public debt, causing sovereign default risk, and thus sovereign spreads, to increase substantially. As a result, the value of government guarantees deteriorates, deepening the crisis in the financial sector. The recent bailout in Ireland clearly illustrates the relevance of such risk transmission mechanism. An additional important contribution of our paper is to determine under which circumstances it is desirable for the government to provide bailout guarantees to the financial sector of the economy. A calibrated version of our model can mimic some of the interaction dynamics between financial sector risks and sovereign risks observed in Ireland during the crisis.
Year of publication: |
2014
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Authors: | Lizarazo, Sandra ; Sapriza, Horacio ; Bianchi, Javier |
Institutions: | Society for Economic Dynamics - SED |
Saved in:
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