Sovereign Credit Risk and Banking Crises

This paper develops a structural model for the valuation of sovereign debt in which a sovereign country faces a strategic default decision under the risk of experiencing a banking crisis. The sovereign’s default policy is governed by the trade-off between lower debt-servicing expenditures and the costs of sovereign default represented by increased financial stress for the local banking sector. The framework developed in this paper yields new insights into the interaction between sovereign credit risk and a country’s financial system. In particular, the model suggests that a large financial sector affects sovereign risk in two ways. On the one hand, it raises sovereign risk by increasing the potential losses in the event of a banking crisis. On the other hand, it lowers sovereign credit risk by committing the sovereign to servicing its debt in the future. Which effect dominates depends on variables such as size of the banking sector within the sovereign’s economy, aggregate financial sector credit risk, and holdings of government bonds by domestic banks.