Sovereign Default, Domestic Banks, and Financial Institutions





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    • Nicola Gennaioli is with Bocconi University and IGIER. Alberto Martin is with CREI, UPF, and Barcelona GSE. Stefano Rossi is with Purdue University, CEPR, and ECGI. We are grateful for helpful suggestions from seminar participants at the American Finance Association meetings, the NBER meetings in International Finance and Macroeconomics, the “Sovereign Debt Risk” conference at the George Weiss Center for International Financial Research at Wharton, Bank of England, Bank of Spain, CERGE-EI, CEU, Helsinki, IAE, Lausanne, New York University Stern School of Business, Samuel Johnson Graduate School of Management at Cornell University, Purdue, PSE, Stockholm School of Economics, University of Vigo, ESSIM, XI Workshop in International Economics and Finance in Montevideo, and the Workshop in Institutions, Contracts, and Growth in Barcelona. We have received helpful comments from Senay Agca, Mark Aguiar, Philippe Bacchetta, Matt Billett, Fernando Broner, Eduardo Fernandez-Arias, Pierre-Olivier Gourinchas, Bernardo Guimaraes, Kose John, Andrew Karolyi, Philip Lane, Andrei Levchenko, Guido Lorenzoni, Romain Rancière, Hélène Rey, David Robinson, Katrin Tinn, and Jaume Ventura. We also thank Campbell Harvey, the Editor, an anonymous referee, and an anonymous Associate Editor. Gonçalo Pina and Robert Zymek provided excellent research assistantship. Gennaioli thanks the European Research Council for financial support and the Barcelona GSE Research Network. Martin acknowledges support from the Spanish Ministry of Science and Innovation (grant Ramon y Cajal RYC-2009-04624), the Spanish Ministry of Economy and Competitivity (grant ECO2011-23192), the Generalitat de Catalunya-AGAUR (grant 2009SGR1157), and the Barcelona GSE Research Network. Martin and Gennaioli acknowledge support from the International Growth Center, project RA-2010-03-2006.


We present a model of sovereign debt in which, contrary to conventional wisdom, government defaults are costly because they destroy the balance sheets of domestic banks. In our model, better financial institutions allow banks to be more leveraged, thereby making them more vulnerable to sovereign defaults. Our predictions: government defaults should lead to declines in private credit, and these declines should be larger in countries where financial institutions are more developed and banks hold more government bonds. In these same countries, government defaults should be less likely. Using a large panel of countries, we find evidence consistent with these predictions.