Banking Regulation with Risk of Sovereign Default

Pablo D'Erasmo, Igor Livshits and Koen Schoors

No 26-25, Working Papers from Federal Reserve Bank of Philadelphia

Abstract: Banking regulation routinely designates domestic government debt as safe, even when this debt is risky. We show, in a parsimonious model, that this failure to recognize the riskiness of government debt induces domestic banks to “gamble” with depositors’ funds by purchasing risky government bonds and assets correlated with them. Sovereign defaults then result in banking crises; however, by permitting banks to gamble, the regulator lowers the government’s borrowing costs ex-ante. Thus, the government has an incentive to ignore the riskiness of the sovereign bonds. We derive a set of testable implications and present supporting empirical evidence from sovereign debt crises in Russia, Argentina, and the Eurozone.

Keywords: Banking; Sovereign default; Prudential regulation; Financial crisis (search for similar items in EconPapers)
JEL-codes: F34 G01 G28 (search for similar items in EconPapers)
Pages: 50
Date: 2026-05-11
New Economics Papers: this item is included in nep-dge, nep-mig and nep-uep
Note: Supersedes 19-15
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedpwp:103190

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DOI: 10.21799/frbp.wp.2026.25

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