Optimal Bailouts in Banking and Sovereign Crises

Sewon Hur, Cesar Sosa-Padilla and Zeynep Yom

No 207, Working Papers from Red Nacional de Investigadores en Economía (RedNIE)

Abstract: We study optimal bailout policies in the presence of banking and sovereign crises. First, we use European data to document that asset guarantees are the most prevalent way in which sovereigns intervene during banking crises. Then, we build a model of sovereign borrowing with limited commitment, where domestic banks hold governmentdebt and also provide credit to the private sector. Shocks to bank capital can trigger banking crises, with the government sometimes finding it optimal to extend guaranteesover bank assets. This leads to a trade-off: Larger bailouts relax domestic financial frictions and increase output, but also imply increasing government fiscal needs andpossible heightened default risk (i.e., they create a ‘diabolic loop’). We find that the optimal bailouts exhibit clear properties. Other things equal, the fraction of bankinglosses that the bailouts cover is: (i) decreasing in the level of government debt; (ii) increasing in aggregate productivity; and (iii) increasing in the severity of the bankingcrisis. Even though bailouts mitigate the adverse effects of banking crises, we find that the economy is ex ante better off without bailouts: Having access to bailouts lowers thecost of defaults, which in turn increases the default frequency, and reduces the levels of debt, output, and consumption.

Keywords: Bailouts; Sovereign Defaults; Banking Crises; Contingent Transfers; Sovereignbank diabolic loop (search for similar items in EconPapers)
JEL-codes: E32 E62 F34 F41 G01 G15 H63 (search for similar items in EconPapers)
Pages: 59 pages
Date: 2022-12
New Economics Papers: this item is included in nep-ban, nep-dge and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
https://rednie.eco.unc.edu.ar/files/DT/207.pdf (application/pdf)

Related works:
Working Paper: Optimal Bailouts in Banking and Sovereign Crises (2024)
Working Paper: Optimal Bailouts in Banking and Sovereign Crises (2024)
Working Paper: Optimal bailouts in banking and sovereign crises (2021)
Working Paper: Optimal Bailouts in Banking and Sovereign Crises (2021)
Working Paper: Optimal Bailouts in Banking and Sovereign Crises (2021)
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Persistent link: https://EconPapers.repec.org/RePEc:aoz:wpaper:207

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