'Government Guarantees and the Two-way feedback between Banking and Sovereign Debt Crises'
|Date||3 February 2015|
|Time||12:30 - 14:00|
I develop a model of self-fulfilling banking and sovereign debt crises where depositors’, investors’ and government’s decision are determined endogenously. In this context, I show that government guarantees to the banking sector generate a two-way feedback between the two crises and induce a trade-off. An increase in the guarantees offered by the government to banks reduces depositors’ incentive to run, but it also negatively affects the state of public finances and, in turn, the likelihood of a sovereign debt crisis. When the former dominates, guarantees are desirable since, despite the potential larger disbursement for the government, they reduce the fragility in both the banking sector and the sovereign debt market, When the latter effect dominates, guarantees may entail large costs and may not be fully effective in preventing panic-driven banking crises. The specific characteristics of the economy like the size of the banking sector, its productivity relative to the one of the public sector, the level of public expenditure and the tax burden determine which of the two scenarios is more likely to occur.