Twin Default Crises

61 Pages Posted: 3 Mar 2020 Last revised: 24 Mar 2020

See all articles by Caterina Mendicino

Caterina Mendicino

Bank of Portugal; European Central Bank (ECB) - Directorate General Research

Kalin Nikolov

European Central Bank (ECB)

Juan Rubio Ramírez

Emory University

Javier Suarez

Centre for Monetary and Financial Studies (CEMFI); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Dominik Supera

University of Pennsylvania - The Wharton School

Multiple version iconThere are 3 versions of this paper

Date Written: February 2020

Abstract

We study the interaction between borrowers' and banks' solvency in a quantitative macroeconomic model with financial frictions in which bank assets are a portfolio of defaultable loans. We show that ex-ante imperfect diversification of bank lending generates bank asset returns with limited upside but significant downside risk. The asymmetric distribution of these returns and their implications for the evolution of bank net worth are important for capturing the frequency and severity of twin default crises -simultaneous rises in firm and bank defaults associated with sizeable negative effects on economic activity. As a result, our model implies higher optimal capital requirements than common specifications of bank asset returns, which neglect or underestimate the impact of borrower default on bank solvency.

Keywords: Bank Fragility, Capital requirements, Default Risk, loan returns, non-diversifiable risk

JEL Classification: E3, E44, G01, G21

Suggested Citation

Mendicino, Caterina and Nikolov, Kalin and Rubio Ramírez, Juan and Suarez, Javier and Supera, Dominik, Twin Default Crises (February 2020). CEPR Discussion Paper No. DP14427, Available at SSRN: https://ssrn.com/abstract=3547360

Caterina Mendicino (Contact Author)

Bank of Portugal ( email )

Rua Francisco Ribeiro, 2
Lisbon, 1150-165
Portugal

European Central Bank (ECB) - Directorate General Research ( email )

Kaiserstrasse 29
D-60311 Frankfurt am Main
Germany

Kalin Nikolov

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Juan Rubio Ramírez

Emory University ( email )

201 Dowman Drive
Atlanta, GA 30322
United States

Javier Suarez

Centre for Monetary and Financial Studies (CEMFI) ( email )

Casado del Alisal 5
28014 Madrid
Spain
+34 91 429 0551 (Phone)
+34 91 429 1056 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

Dominik Supera

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

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