Sovereign Default Risk and Bank Fragility in Financially Integrated Economies

Patrick Bolton and Olivier Jeanne

No 8358, CEPR Discussion Papers from Centre for Economic Policy Research

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 (search for similar items in EconPapers)
JEL-codes: E44 F34 F36 G21 H63 (search for similar items in EconPapers)
Date: 2011-04
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Citations: View citations in EconPapers (296)

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Related works:
Journal Article: Sovereign Default Risk and Bank Fragility in Financially Integrated Economies (2011)
Working Paper: Sovereign Default Risk and Bank Fragility in Financially Integrated Economies (2011)
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