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Banking Regulation with Risk of Sovereign Default

Pablo D'Erasmo (), Igor Livshits () and Koen Schoors

No 19-15, Working Papers from Federal Reserve Bank of Philadelphia

Abstract: Banking regulation routinely designates some assets as safe and thus does not require banks to hold any additional capital to protect against losses from these assets. A typical such safe asset is domestic government debt. There are numerous examples of banking regulation treating domestic government bonds as ?safe,? even when there is clear risk of default on these bonds. We show, in a parsimonious model, that this failure to recognize the riskiness of government debt allows (and induces) domestic banks to ?gamble? with depositors? funds by purchasing risky government bonds (and assets closely correlated with them). A sovereign default in this environment then results in a banking crisis. Critically, we show that permitting banks to gamble this way lowers the cost of borrowing for the government. Thus, if the borrower and the regulator are the same entity (the government), that entity has an incentive to ignore the riskiness of the sovereign bonds. We present empirical evidence in support of the key mechanism we are highlighting, drawing on the experience of Russia in the run-up to its 1998 default and on the recent Eurozone debt crisis.

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: 42 pages
Date: 2019-02-22
New Economics Papers: this item is included in nep-ban, nep-cba, nep-cis, nep-opm and nep-tra
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DOI: 10.21799/frbp.wp.2019.15

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