Sovereign debt and bank fragility in Spain

In May 2012 the Spanish government announced a debt-financed recapitalization of the undercapitalized Spanish banking system. Although there was a wide consensus among economists and policymakers that this was key to solving Spain’s economic troubles, both bank CDS and sovereign CDS further increased in the days following the announcement while lower bank CDS spreads were expected. Higher sovereign debt discounts deteriorated the fiscal position of the Spanish government. We propose a mechanism that can explain the events in Spain, namely the interaction whereby weak banks that are heavily exposed to risky domestic sovereign debt and weak government finances set off a negative amplification cycle: additional debt issue leads to higher sovereign debt discounts, resulting in capital losses on existing sovereign debt, deteriorating the capital base of banks, additional rounds of interest rate increases, a perverse amplification cycle substantially offsetting the initial recapitalization. We construct a DSGE model with balance-sheet-constrained financial intermediaries that finance private loans to the real economy, as well as sovereign debt subject to sovereign default risk. We calibrate the model to Spanish data, and find that our model is capable of matching the developments in the sovereign bond market in Spain in May/June 2012 quite well. We investigate an alternative policy, direct recapitalization by a foreign entity, such as the ESM, which avoids the negative sovereign risk amplification cycle.