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Sovereign Risk and Bank Balance Sheets: The Role of Macroprudential Policies

Author

Listed:
  • Pablo D'Erasmo

    (University of Maryland / FRB Philadelphi)

  • Bora Durdu

    (Federal Reserve Board)

  • Emine Boz

    (International Monetary Fund)

Abstract

This paper explores the role of bank balance sheets, sovereign default risk, and capital adequacy requirements in amplifying aggregate fluctuations. The paper, first, proposes a unified model of defaultable sovereign debt and bank balance sheets to capture regularities on bank credit to firms, banks' holdings of sovereign bonds, and the behavior of sovereign debt and default. The model captures the procyclical bank credit and countercyclical bank holdings of sovereign bonds. Since the sovereign defaults indiscriminately, bank losses due to a default hampers its lending to firms, thereby, generating an endogenous cost of default. The paper then conducts counterfactual policy experiments in line with Basel III. Our preliminary findings suggest that the introduction of leverage ratios is superior to increasing the capital requirement on risk weighted assets where sovereign bonds are assigned a zero weight.

Suggested Citation

  • Pablo D'Erasmo & Bora Durdu & Emine Boz, 2014. "Sovereign Risk and Bank Balance Sheets: The Role of Macroprudential Policies," 2014 Meeting Papers 641, Society for Economic Dynamics.
    • Handle: RePEc:red:sed014:641
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    References listed on IDEAS

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    6. Aguiar, Mark & Gopinath, Gita, 2006. "Defaultable debt, interest rates and the current account," Journal of International Economics, Elsevier, vol. 69(1), pages 64-83, June.
    7. Sosa-Padilla, César, 2018. "Sovereign defaults and banking crises," Journal of Monetary Economics, Elsevier, vol. 99(C), pages 88-105.
    8. Jonathan Eaton & Mark Gersovitz, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 48(2), pages 289-309.
    9. Kishan, Ruby P & Opiela, Timothy P, 2000. "Bank Size, Bank Capital, and the Bank Lending Channel," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(1), pages 121-141, February.
    10. Enrique G. Mandoza & Vivian Z. Yue, 2008. "A solution to the default risk-business cycle disconnect," International Finance Discussion Papers 924, Board of Governors of the Federal Reserve System (U.S.).
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    Citations

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    Cited by:

    1. Sewon Hur & César Sosa-Padilla & Zeynep Yom, 2021. "Optimal bailouts in banking and sovereign crises," Working Papers 51, Red Nacional de Investigadores en Economía (RedNIE).
    2. Pablo D'Erasmo & Enrique G. Mendoza, 2016. "Distributional Incentives In An Equilibrium Model Of Domestic Sovereign Default," Journal of the European Economic Association, European Economic Association, vol. 14(1), pages 7-44, February.
    3. D’Erasmo, P. & Mendoza, E.G. & Zhang, J., 2016. "What is a Sustainable Public Debt?," Handbook of Macroeconomics, in: J. B. Taylor & Harald Uhlig (ed.), Handbook of Macroeconomics, edition 1, volume 2, chapter 0, pages 2493-2597, Elsevier.
    4. Rojas, Luis E. & Thaler, Dominik, 2023. "The bright side of the doom loop: banks’ sovereign exposure and default incentives," Working Paper Series 2869, European Central Bank.
    5. Enrico Mallucci, 2022. "Domestic Debt and Sovereign Defaults," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 54(6), pages 1741-1775, September.
    6. Burcu Eyigungor, 2017. "Government Debt in Domestic Hands During a Crisis," Economic Insights, Federal Reserve Bank of Philadelphia, vol. 2(3), pages 1-8, July.
    7. D’Erasmo, Pablo & Livshits, Igor & Schoors, Koen, 2024. "Banking regulation with risk of sovereign default," Journal of International Economics, Elsevier, vol. 150(C).
    8. Dominik Thaler, 2021. "Sovereign Default, Domestic Banks and Exclusion from International Capital Markets," The Economic Journal, Royal Economic Society, vol. 131(635), pages 1401-1427.
    9. Capponi, Agostino & Corell, Felix & Stiglitz, Joseph E., 2022. "Optimal bailouts and the doom loop with a financial network," Journal of Monetary Economics, Elsevier, vol. 128(C), pages 35-50.
    10. Faia, Ester, 2017. "Sovereign risk, bank funding and investors’ pessimism," Journal of Economic Dynamics and Control, Elsevier, vol. 79(C), pages 79-96.
    11. Fueki, Takuji & Hürtgen, Patrick & Walker, Todd B., 2024. "Zero-risk weights and capital misallocation," Journal of Financial Stability, Elsevier, vol. 72(C).
    12. Luis Rojas & Dominik Thaler, 2020. "The Bright Side of the Doom Loop: Banks Exposure and Default Incentives," Working Papers 1143, Barcelona School of Economics.

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