Sovereign Default, Domestic Banks and Financial Institutions

Abstract

We build a model where sovereign defaults weaken banks' balance sheets because banks hold sovereign bonds, causing private credit to decline. Stronger financial institutions boost default costs by amplifying these balance-sheet effects. This yields a novel complementarity between public debt and domestic credit markets, where the latter sustain the former by increasing the costs of default. We document three novel empirical facts that are consistent with our model's predictions: public defaults are followed by large private credit contractions; these contractions are stronger in countries where banks hold more public debt and financial institutions are stronger; in these same countries default is less likely.

Keywords: Capital Flows, Financial Liberalization, Institutions, Sovereign Risk, Sudden Stops

JEL Classification: F34, F36, G15, H63