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Optimal Bailouts in Banking and Sovereign Crises

Author

Listed:
  • Sewon Hur
  • César Sosa-Padilla
  • Zeynep Yom
Abstract
We study optimal bailout policies amidst banking and sovereign crises. Our model features sovereign borrowing with limited commitment, where domestic banks hold government debt and extend credit to the private sector. Bank capital shocks can trigger banking crises, prompting the government to consider extending guarantees over bank assets. This poses a trade-off: Larger bailouts relax financial frictions and increase output, but increase fiscal needs and default risk (creating a ‘diabolic loop’). Optimal bailouts exhibit clear properties. The fraction of banking losses the bailouts cover is (i) decreasing in government debt; (ii) increasing in aggregate productivity; and (iii) increasing in the severity of banking crises. Even though bailouts mitigate the adverse effects of banking crises, the economy is ex ante better off without bailouts: Having access to bailouts lowers the cost of defaults, which in turn increases the default frequency, and reduces the levels of debt, output, and consumption.

Suggested Citation

  • Sewon Hur & César Sosa-Padilla & Zeynep Yom, 2021. "Optimal Bailouts in Banking and Sovereign Crises," NBER Working Papers 28412, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:28412
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    References listed on IDEAS

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    Cited by:

    1. Arce, Fernando, 2021. "Private Overborrowing under Sovereign Risk," MPRA Paper 113176, University Library of Munich, Germany.
    2. Sosa-Padilla, César & Sturzenegger, Federico, 2023. "Does it matter how central banks accumulate reserves? Evidence from sovereign spreads," Journal of International Economics, Elsevier, vol. 140(C).
    3. Capponi, Agostino & Corell, Felix & Stiglitz, Joseph E., 2022. "Optimal bailouts and the doom loop with a financial network," Journal of Monetary Economics, Elsevier, vol. 128(C), pages 35-50.
    4. Tamon Asonuma & Michael G. Papaioannou & Takahiro Tsuda, 2021. "Banking Crisis, Sovereign Debt Restructurings, and Financial Stability Policies in Cyprus During 2012–13," Multinational Finance Journal, Multinational Finance Journal, vol. 25(3-4), pages 163-186, September.

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    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems

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