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Bankruptcy Codes and Risk Sharing of Currency Unions

Xuan Wang ()

No 21-009/IV, Tinbergen Institute Discussion Papers from Tinbergen Institute

Abstract: Since the Eurozone Crisis of 2010-12, a critical debate on the viability of a currency union has focused on the role of a fiscal union in adjusting for country heterogeneity. However, a fully-fledged fiscal union may not be politically feasible. This paper develops a two-country general equilibrium model to examine the benefits of the bankruptcy code of a capital markets union - in the absence of a fiscal union - as an alternative mechanism to improve the financial stability and welfare of a currency union. When domestic credit risks are present, I show that a lenient bankruptcy code in the cross-border capital markets union removes the pecuniary externality of banking insolvency, so it leads to a Pareto improvement within the currency union. Moreover, the absence of floating nominal exchange rates removes a mechanism to neutralise domestic credit risks; I show that softening the bankruptcy code can recoup the lost benefits of floating nominal exchange rates. The model provides the financial stability and welfare implications of bankruptcy within a capital markets union in the Eurozone.

Keywords: Equilibrium default; bankruptcy code; fiscal union; capital markets union; financial stability; bank credit and inside money; price-level and exchange rate determinacy; liquidity-intermediary asset pricing (search for similar items in EconPapers)
JEL-codes: E42 F33 G15 G21 (search for similar items in EconPapers)
Date: 2021-01-21
New Economics Papers: this item is included in nep-dge, nep-eec, nep-mac and nep-mon
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