Banks and Sovereigns: A Model of Mutual Contagion

The recent crisis has revealed that bank and sovereign risks are inherently intertwined. This paper develops a model of the bank-sovereign nexus to identify the main spillovers and to study the implications of guarantees and capital regulation. We show how banks’ asset risk may trigger a sovereign default through taxation and deposit insurance. The latter can be contagious because of its cost or stabilizing by avoiding liquidation losses. Since sovereign risks receive preferential regulatory treatment, banks purchase government bonds. This creates the opportunity for adverse feedback loops such that a sovereign default is the very reason for bank failure.