Abstract
The paper analyzes contagious sovereign debt crises in financially integrated economies. Under financial integration banks optimally diversify their holdings of sovereign debt in an effort to minimize the costs with respect to an individual country's sovereign debt default. Although diversification generates risk diversification benefits ex ante, it also generates contagion ex post. The paper shows that financial integration without fiscal integration results in an inefficient equilibrium supply of government debt. The safest governments inefficiently restrict the amount of high-quality debt that could be used as collateral in the financial system and the riskiest governments issue too much debt, as they do not take account of the costs of contagion. Those inefficiencies can be removed by various forms of fiscal integration, but fiscal integration typically reduces the welfare of the country that provides the “safe-haven” asset below the autarky level.
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Notes
The fact that banks are exposed to the risk of default on government debt, including foreign government debt, has been observed in previous crises. This was true in the debt crises of the 1980s (where advanced-country banks were hit by sovereign defaults, mostly in Latin America) and in the crises of the 1990s (for example, Mexico, Russia, Argentina). The form of the contagion across countries has changed, however, as government debt increasingly took the form of bonds that could be held by nonbank investors. Also, the fact that bonds were continuously traded and priced in secondary markets has accelerated contagion, even if the risk could be more evenly spread between bank and nonbank investors.
The member banks of the European System of Central Banks (ESCB) would start buying government debt in “those market segments which are dysfunctional.” The ESCB's decision was motivated by the belief that the price of certain government debts had reached levels that were abnormally low, given the commitment of those governments to fiscal adjustment. The reasons for this alleged mispricing were not made explicit.
The EFSF was endowed with €750 billion of resources. The EFSF can issue up to €440 billion of debt the market to raise the funds needed to provide loans to crisis countries in the euro area. These resources are augmented by 60 billion coming from the European Financial Stabilisation Mechanism (EFSM), that is funds raised by the European Commission, and up to 250 billion from the International Monetary Fund (IMF). The EFSF should access markets only after a euro member has submitted a request for support. The first EFSF bonds were issued in January 2011 as part of the EU/IMF financial support package for Ireland.
In order to pass the stress test a bank needed to have a Tier 1 capital ratio in excess of 6 percent, in line with the benchmark used in the U.S. stress test.
It is partly thanks to those credit enhancements that the EFSF received the top rating from all three major credit rating agencies in September 2010.
The number of 14.9 percent reported for Europe is an underestimate because it does not include the banks that were not covered by the stress test. It is a cross-country average of the share of government debt held by domestic banks and so does not include government debt held by foreign European banks. If we consolidate government debt across Europe, we find that 26 percent of European government debt was held by European banks.
This share is of course much larger (47.3 percent) if one also includes the foreign official sector—mainly foreign central banks that have accumulated U.S. Treasury securities as international reserves.
The 18 countries whose banking sector is covered by the test are Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Luxembourg, the Kingdom of the Netherlands—Netherlands, the Republic of Poland, Portugal, the Republic of Slovenia, Spain, Sweden and the United Kingdom.
The data are available in excel format at http://www.piie.com/realtime/?p=1711, thanks to Jacob Kirkegaard of the Peterson Institute for International Economics.
The shares reported in Figure 2 are likely to be underestimates as they reflect only the banks included in the stress test.
As mentioned in the introduction, one can think of other channels that do not involve the role of government debt as collateral in the interbank market. The assumption that matters for our analysis, in reduced form, is that a fall in the price of government debt negatively affects the banking sector.
We could assume that banks with investment opportunities can purchase government bonds in the secondary market so as to increase their collateralized borrowing capacity. However, the analysis becomes more involved, without adding major new insights. For simplicity, therefore, we do not allow banks with investment opportunities to purchase government bonds in the secondary market in period 1.
Recall that we have assumed that consumption at any date must be non-negative, c t ≥0, so that the maximum amount any banker can lend in period 1 is y 1.
The government repays its debt b in period 2, but at the same time levies a tax T to repay its debt. This is why b does not appear (in the aggregate) in period-2 consumption.
Note that this expression does not include the utility from the public expenditure g. Adding a constant term would obviously not change any of the results, so that we simply normalize the utility from the public expenditure to zero.
We have ∂f(min(I *, y 1+λb))/∂b=f′(y 1+λb)+ since the marginal net return f′(I) is equal to zero for I=I * and is negative for I larger than I *.
This is not necessarily true because P(b) is decreasing with b. One could imagine a situation in which the government can levy a given level of funds by issuing a large amount of bonds at a low price or a smaller amount of bonds at a higher price. This possibility does not complicate the analysis in an interesting way and we rule it out in the following.
When the U.S. government debt was shrinking in the late 1990s, some economists expressed the concern that it might ultimately become insufficient for the financial system to operate efficiently. This is clearly no longer an issue.
The analysis can be straightforwardly generalized to allow for a positive recovery value 0≤β<b, and a positive price p 1=β in period 1 in the event of default. As no substantive new insight is obtained from this more general model we assume for simplicity that β=0.
Admittedly, under the latter scenario, the timing of the model would have to be changed as follows. In period 1, bankers with investment opportunities would invest in two stages: first, they invest their endowment y 1, and subsequently they would learn whether their investment pays off or not. If it pays off (with probability (1−π)) the government has enough fiscal revenues to be able to service its debt, in which case p 1=b and bankers can in a second step expand their investment opportunity by borrowing d=λb. If it does not pay off (with probability π) the government does not get enough tax revenues in period 2 to be able to repay its debt. The banking “crisis” then triggers a debt crisis.
To be precise, the allocation of the debt without collateral premium is indeterminate. We pin it down by restricting attention to symmetric equilibria, where all bankers choose the same portfolio allocation unless they have a strict reason not to do so. The allocation of the debt with a collateral premium is uniquely determined.
This is one interpretation of what the European Financial Stabilization Fund was created to do (buy risky government debt by issuing debt that is guaranteed by the fiscally safe governments).
Note that we assume that the level of safe government debt can be increased without making it more risky. That is, we are considering debt increases that are not large enough to endanger the solvency of the government in the safe country.
We assume that this commitment is possible one period ahead, in t=1 but not in t=0. If the risky country could commit to the fiscal adjustment in period 0, it would always do so and there would be no crisis.
Without much loss of generality, we restrict attention to mechanisms that prevent default completely rather than merely increase the debt recovery value in a partial default. Also, our model is too pared down to allow for a meaningful distinction between a sovereign bailout and a bank rescue (see Philippon, 2010, for an analysis of bank recapitalization in an open economy).
Note that in this model, commitment reduces total welfare. The sum of the welfare of the two countries is maximized under discretion. This is because commitment is put at the service of extracting a monopoly rent.
We could assume that the tax base is gross output ω(I+θf(I)) without changing the qualitative results.
This type of lending-in-last resort can be implemented by a fund such as the EFSF or by central banks.
Alternatively, one could assume that the safe country has a higher level of τ, so that it does not default even if productivity is low.
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Additional information
*Olivier Jeanne is Professor of Economics at Johns Hopkins University and senior fellow at the Peterson Institute for International Economics. His areas of research are in international macroeconomics, monetary policy, and the intersection between macroeconomics and finance. Patrick Bolton is the Barbara and David Zalaznick Professor of Business and member of the Committee on Global Thought at Columbia University. He is also co-director of the Center for Contracts and Economic Organization at the Columbia Law School. His areas of interest are in Corporate Finance, Banking, Sovereign Debt, Political Economy, and Law and Economics. Paper prepared for the 2010 IMF Annual Research Conference, November 4–5, 2010. The authors thank their discussant, Carlos Végh, two anonymous referees, as well as Pierre-Olivier Gourinchas and Ayhan Kose for helpful comments.
Appendix
Appendix
Proof of Proposition 1
Based on the discussion preceding the Proposition, the only result that remains to be shown, to prove points (i) and (ii) of the Proposition, is that if b *<g<2b * we have
so that the banking sector is constrained if and only if the risky government defaults. Using Equations (6) and (7) the market equilibrium conditions (8) and (9) can be written
and
where function P(·) was defined at the end of section III. Adding up those two equations gives
One cannot have b S +b R <b *. Since P(b)b is increasing in b this would imply
which cannot be true because g is assumed to be larger than b * (Equation (3)). It follows that P(b S +b R )=1 and the budget constraint for the safe country is
The l.h.s. is increasing with b S and for b S =b * it is equal to [1−π+πP(b *)]b *=b *, which is larger than g/2 by assumption. So the equilibrium level of b S must be smaller than b *.
As for point (iii) of the Proposition, we write the welfare levels under autarky as
Using expressions (12) and (13) for the welfare levels of the two countries under integration, and expression (10) to substitute out p S0, we find that the welfare gains from financial integration for the safe and risky countries are respectively
where the positive sign results from the concavity of f(·) and, for ΔU S , from y 1+2λb s >I *.