Policy responses to sovereign debt induced banking crises : a model-based evaluation of alternatives

Using a system dynamics framework, this chapter examines the relationship between sovereign debt dynamics and the stability of financial institutions. It also assesses the effectiveness of various policy options aimed at restoring stability after severe macro-financial shocks. The system dynamics model incorporates three sectors: a banking sector, a central government and a rating agency. The banks and the central government are assumed to be boundedly rational and backward looking, interacting via both the local and international capital markets. Further, the credit rating agency is assumed to be rational and forward-looking. The framework identifies the transmission mechanisms linking sovereign debt and financial sector crises when these three actors interact over time. Although the calibrated model is informed by Jamaican data and the debt situation which has prevailed there since the global financial crisis, the model provides a framework for the consideration of sovereign debt crises in other emerging countries. The model promotes a causality-driven explanation for the reasons behind increasingly unsustainable debt-deficit dynamics and how these imbalances can spill-over into the banking sector leading to increased financial fragility. The chapter closes with some policy implications and recommendations for regulatory reform of the banking sector.