SOGEI website background

Breaking the Sovereign-Bank Nexus

This paper develops a non-linear dynamic general equilibrium model which features endogenous bank failure and sovereign default risk. It aims to quantitatively study the feedback loop between sovereign and banking crises, and to assess the effectiveness of capital requirements in addressing it. In the model, bank failure contributes to an increase of sovereign default risk through the government bailout of bank creditors. Meanwhile, holding high-yield risky sovereign bonds may be attractive to banks protected by limited liability. By increasing banks’ failure risk and their funding costs, sovereign exposures hurt bank lending and contribute to further contractions in aggregate economic activity. Capital requirements, by making banks safer, weaken the sovereign-bank nexus, at the cost of constraining credit supply. The results, thus, point to the existence of non-trivial welfare trade-offs when setting the optimal regulation.