Twin Default Crises

60 Pages Posted: 26 May 2020

See all articles by Caterina Mendicino

Caterina Mendicino

European Central Bank (ECB) - Directorate General Research

Kalin Nikolov

European Central Bank (ECB)

Dominik Supera

University of Pennsylvania - The Wharton School

Juan-Rubio Ramirez

affiliation not provided to SSRN

Multiple version iconThere are 3 versions of this paper

Date Written: May, 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 capital requirements, bank default, financial crises, firm default

JEL Classification: G01, G28, E44

Suggested Citation

Mendicino, Caterina and Nikolov, Kalin and Supera, Dominik and Ramirez, Juan-Rubio, Twin Default Crises (May, 2020). ECB Working Paper No. 20202414, Available at SSRN: https://ssrn.com/abstract=3609868

Caterina Mendicino (Contact Author)

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

Dominik Supera

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

Juan-Rubio Ramirez

affiliation not provided to SSRN

No Address Available

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