Sovereign Default Risk and Bank Fragility in Financially Integrated Economies

48 Pages Posted: 4 May 2011

See all articles by Patrick Bolton

Patrick Bolton

Imperial College London; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Olivier Jeanne

Johns Hopkins University - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: April 2011

Abstract

We analyze contagious sovereign debt crises in financially integrated economies. Under financial integration banks optimally diversify their holdings of sovereign debt in an effort to minimize the costs with respect to an individual country's sovereign debt default. While diversification generates risk diversification benefits ex ante, it also generates contagion ex post. We show that financial integration without fiscal integration results in an inefficient equilibrium supply of government debt. The safest governments inefficiently restrict the amount of high quality debt that could be used as collateral in the financial system and the riskiest governments issue too much debt, as they do not take account of the costs of contagion. Those inefficiencies can be removed by various forms of fiscal integration, but fiscal integration typically reduce the welfare of the country that provides the "safe-haven" asset below the autarky level.

Keywords: banking, collateral, European debt crisis, European Monetary Union, financial contagion, government debt, government default, international financial integration

JEL Classification: E44, F34, F36, G21, H63

Suggested Citation

Bolton, Patrick and Jeanne, Olivier, Sovereign Default Risk and Bank Fragility in Financially Integrated Economies (April 2011). CEPR Discussion Paper No. DP8358, Available at SSRN: https://ssrn.com/abstract=1830976

Patrick Bolton (Contact Author)

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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

Olivier Jeanne

Johns Hopkins University - Department of Economics ( email )

3400 Charles Street
Baltimore, MD 21218-2685
United States

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