Sovereign Default Risk and Bank Fragility in Financially Integrated Economies

The paper analyzes contagious sovereign debt crises in financially integrated economies. Under financial integration banks optimally diversify their holdings of sovereign debt in an effort to minimize the costs with respect to an individual country's sovereign debt default. Although diversification generates risk diversification benefits ex ante, it also generates contagion ex post. The paper shows that financial integration without fiscal integration results in an inefficient equilibrium supply of government debt. The safest governments inefficiently restrict the amount of high-quality debt that could be used as collateral in the financial system and the riskiest governments issue too much debt, as they do not take account of the costs of contagion. Those inefficiencies can be removed by various forms of fiscal integration, but fiscal integration typically reduces the welfare of the country that provides the “safe-haven” asset below the autarky level.