Intertwined sovereign and bank solvencies in a simple model of self-fulfilling crisis

The financial crisis in the periphery of Europe, similar to previous crises in emerging markets, has shown that large fiscal financing needs are often met by borrowing heavily from domestic banking systems. As public debt approaches sustainability limits, however, banks' high exposure to sovereign risk creates a fragile inter-dependence between fiscal and bank solvency. The paper presents a simple model that illustrates how this interdependence creates conditions conducive to a self-fulfilling twin crisis; and discusses possible financial arrangements that can prevent crisis equilibria.