Optimal Bailouts in Banking and Sovereign Crises / Sewon Hur, César Sosa-Padilla, Zeynep Yom.

Format:

Book

Author/Creator:

Hur, Sewon.

Contributor:

National Bureau of Economic Research.

Sosa-Padilla, César.

Yom, Zeynep.

Series:

Working Paper Series (National Bureau of Economic Research) no. w28412.

NBER working paper series no. w28412

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2021.

Summary:

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 government debt 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 guarantees over bank assets. This leads to a trade-off: Larger bailouts relax domestic financial frictions and increase output, but also imply increasing government fiscal needs and possible 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 banking losses 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 banking crisis. 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 the cost of defaults, which in turn increases the default frequency, and reduces the levels of debt, output, and consumption.

Notes:

Print version record

January 2021.