Domestic Banking Fragility and Sovereign Debt Capacity

Abstract

I quantitatively analyze the interaction between domestic bank runs and the sovereign’s debt, default, and international reserve policies. The model uses global game techniques to relate the unique domestic bank run outcome to the health of the sovereign’s external balance sheet. In equilibrium, the sovereign’s external balance sheet conditions determine its ability to prevent domestic bank runs. I find that domestic banking fragility gives rise to (1) endogenous costs of sovereign default, and (2) a financial stabilization role for international reserves. The model generates realistic levels of debt and reserves in equilibrium, and the interaction between sovereign defaults and domestic banking crises.

Keywords: Sovereign Debt, International Reserves, Bank Runs, Gobal Games

JEL Classification: F34, F41, G01, G21, H63