Banking Regulation with Risk of Sovereign Default

42 Pages Posted: 25 Feb 2019 Last revised: 29 Apr 2020

See all articles by Pablo D'Erasmo

Pablo D'Erasmo

Federal Reserve Banks - Federal Reserve Bank of Philadelphia; University of Maryland - College Park

Igor Livshits

Federal Reserve Bank of Philadelphia; University of Western Ontario - Department of Economics

Koen Schoors

Ghent University

Date Written: 2019-02-22

Abstract

Banking regulation routinely designates some assets as safe and thus does not require banks to hold any additional capital to protect against losses from these assets. A typical such safe asset is domestic government debt. There are numerous examples of banking regulation treating domestic government bonds as “safe,� even when there is clear risk of default on these bonds. We show, in a parsimonious model, that this failure to recognize the riskiness of government debt allows (and induces) domestic banks to “gamble� with depositors’ funds by purchasing risky government bonds (and assets closely correlated with them). A sovereign default in this environment then results in a banking crisis. Critically, we show that permitting banks to gamble this way lowers the cost of borrowing for the government. Thus, if the borrower and the regulator are the same entity (the government), that entity has an incentive to ignore the riskiness of the sovereign bonds. We present empirical evidence in support of the key mechanism we are highlighting, drawing on the experience of Russia in the run-up to its 1998 default and on the recent Eurozone debt crisis.

Keywords: Banking, Sovereign default, Prudential regulation, Financial crisis

JEL Classification: F34, G01, G28

Suggested Citation

D'Erasmo, Pablo and Livshits, Igor and Schoors, Koen, Banking Regulation with Risk of Sovereign Default (2019-02-22). FRB of Philadelphia Working Paper No. 19-15. Available at SSRN: https://ssrn.com/abstract=3340122 or http://dx.doi.org/10.21799/frbp.wp.2019.15

Pablo D'Erasmo (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

University of Maryland - College Park ( email )

College Park, MD 20742
United States

Igor Livshits

Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

University of Western Ontario - Department of Economics ( email )

London, Ontario N6A 5B8
Canada

Koen Schoors

Ghent University

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