Episodes of sovereign default feature three key empirical regularities in connection with the
banking systems of the countries where they occur: (i) sovereign defaults and banking crises tend
to happen together, (ii) commercial banks have substantial holdings of government debt, and (iii)
sovereign defaults result in major contractions in bank credit and production. This paper provides
a rationale for these phenomena by extending the traditional sovereign default framework to
incorporate bankers ...
Episodes of sovereign default feature three key empirical regularities in connection with the
banking systems of the countries where they occur: (i) sovereign defaults and banking crises tend
to happen together, (ii) commercial banks have substantial holdings of government debt, and (iii)
sovereign defaults result in major contractions in bank credit and production. This paper provides
a rationale for these phenomena by extending the traditional sovereign default framework to
incorporate bankers who lend to both the government and the corporate sector. When these
bankers are highly exposed to government debt, a default triggers a banking crisis, which leads
to a corporate credit collapse and subsequently to an output decline. When calibrated to the 2001-
02 Argentine default episode, the model is able to produce default in equilibrium at observed
frequencies, and when defaults occur credit contracts sharply, generating output drops of 7
percentage points, on average. Moreover, the model matches several moments of the data on
macroeconomic aggregates, sovereign borrowing, and fiscal policy. The framework presented
can also be useful for studying the optimality of fractional defaults.
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