Financial Fragility, Sovereign Default Risk and the Limits to Commercial Bank Bail-Outs

Tinbergen Institute Discussion Paper 13-179/VI/DSF65

45 Pages Posted: 29 Jan 2016

See all articles by Sweder van Wijnbergen

Sweder van Wijnbergen

Universiteit van Amsterdam; Tinbergen Institute; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Christiaan van der Kwaak

University of Amsterdam

Date Written: October 25, 2013

Abstract

We analyze the poisonous interaction between bank rescues, financial fragility and sovereign debt discounts. In our model balance sheet constrained financial intermediaries finance both capital expenditure of intermediate goods producers and government deficits. The financial intermediaries face the risk of a (partial) default of the government on its debt obligations. We analyze the impact of a financial crisis, first under full government credibility and then with an endogenous sovereign debt discount. We introduce long term government debt, which gives rise to the possibility of capital losses on bank balance sheets. The negative feedback effects from falling bond prices on the economy are shown to increase with the average duration of the government bonds, as higher interest rates on new debt lead to capital losses on banks' holding of existing long term (government) debt. The associated increase in credit tightness leads to a negative amplification effect, significantly increasing output losses and declines in investment after a financial crisis. We introduce sovereign default risk through the existence of a maximum sustainable level of debt, derived from the maximum level of taxation that is politically feasible. When close to this limit, sovereign discounts emerge reflecting potential defaults on debt, creating a strong link between sovereign default risk and financial fragility emerges. A debt-financed recapitalization of the financial intermediaries causes bond prices to drop triggering capital losses at the bank under intervention. This mechanism shows the limits to conventional bank bail-outs in countries with fragile public creditworthiness, limits that became very visible during the Great Recession in Southern Europe.

Keywords: Financial Intermediation; Macrofinancial Fragility; Fiscal Policy; Sovereign Default Risk

JEL Classification: E44; E62; H30

Suggested Citation

van Wijnbergen, Sweder and van der Kwaak, Christiaan, Financial Fragility, Sovereign Default Risk and the Limits to Commercial Bank Bail-Outs (October 25, 2013). Tinbergen Institute Discussion Paper 13-179/VI/DSF65. Available at SSRN: https://ssrn.com/abstract=2345296 or http://dx.doi.org/10.2139/ssrn.2345296

Sweder Van Wijnbergen (Contact Author)

Universiteit van Amsterdam ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands
+31 20 525 4011 / 4203 (Phone)
+31-35-624 91 82 (Fax)

Tinbergen Institute

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Christiaan Van der Kwaak

University of Amsterdam ( email )

Spui 21
Amsterdam, 1018 WB
Netherlands

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