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Sovereign Default Risk and Bank Fragility in Financially Integrated Economies

This paper considers government debt management, sovereign default risk, and the implications of sovereign debt crises for the banking sector in financially integrated economies. The recent literature on sovereign debt has generally abstracted from the link between a sovereign debt crisis in a country and contagion to other countries through an integrated banking system.

But, as the recent European sovereign debt crisis has highlighted, contagion of the crisis in one country to other countries through the banking system can be a major issue. When the safety of a country's government debt starts being questioned, problems quickly spill over to the fi nancial system and, given the high degree of international fi ancial integration, to other countries.

A rst question we address is, what determines bank portfolios of sovereign debt? Why do banks hold sovereign bonds and why do they diversify their government debt holdings? A second, closely related question, is how government debt management policies are aff ected by banks' demand for government bonds? Given that there is a risk of contagion of a crisis through an integrated banking system, a third question is how countries that are potentially aeffcted by the crisis deal with the costly fiscal adjustments that may be necessary to forestall it?

This latter question, in particular, has been at the core of the European crisis, and underlies the debates around the European Financial Stabilization Fund that has been set up to deal with the Greek, Irish, and possibly other European Union `peripheral' member-country sovereign debt crises. Finally, given the potential contagion risk and fiscal adjustment costs that may come with greater financial integration, a fourth question is whether these risks and costs may eliminate the bene fits of greater integration altogether?

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Sovereign Default Risk and Bank Fragility in Financially Integrated Economies