Financial Stability with Sovereign Debt

35 Pages Posted: 9 Feb 2020

Date Written: January 15, 2020


Are government guarantees or financial regulation a more effective way to prevent banking crises? I study this question in the presence of a negative feedback loop between the fiscal position of the government and the health of the banking sector. I construct a model of financial intermediation in which the government issues, and may default on, debt. Banks hold some of this debt, which ties their health to that of the government. The government’s tax revenue, in turn, depends on the quantity of investment that banks are able to finance. I compare the effectiveness of government guarantees, liquidity regulation, and a combination of these policies in preventing self-fulfilling bank runs. In some cases, a combination of the two policies is needed to prevent a run. In other cases, liquidity regulation alone is effective and adding guarantees would make the financial system fragile.

Keywords: Bank runs, Sovereign debts, Feedback loop, Government guarantees, Liquidity regulations

JEL Classification: G21, G28, H63

Suggested Citation

Izumi, Ryuichiro, Financial Stability with Sovereign Debt (January 15, 2020). Available at SSRN: or

Ryuichiro Izumi (Contact Author)

Wesleyan University ( email )

Middletown, CT 06459
United States


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