Sovereign risk and bank fragility

Kartik Anand and Jochen Mankart

No 54/2020, Discussion Papers from Deutsche Bundesbank

Abstract: We develop a model of bank risk-taking with strategic sovereign default risk. Domestic banks invest in real projects and purchase government bonds. While an increase in bond purchases crowds out profitable investments, it improves the government's incentives to repay and therefore lowers its borrowing costs. For low levels of government debt, banks influence their default risks through purchases of bonds. But, for high debt levels, this influence is lost since bank and government default are perfectly correlated. Banks fail to account for how their bond purchases influence the government's default incentives. This leads to socially inefficient levels of bond holdings.

Keywords: sovereign debt; financial intermediation; financial repression; bank fragility (search for similar items in EconPapers)
JEL-codes: G01 G21 G28 (search for similar items in EconPapers)
Date: 2020
New Economics Papers: this item is included in nep-ban and nep-rmg
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:zbw:bubdps:542020

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