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The Growth of Finance, Financial Innovation, and
Systemic Risk
Lecture 5
BGSE Summer School in Macroeconomics, July 2013
Nicola Gennaioli, Universita’ Bocconi, IGIER and CREI
Banks and Sovereign Default Risk2
Link between government default and private sector turmoil
Russia 1998, but also Pakistan, Ecuador and Argentina (IMF 2002)
European debt crisis: joint fragility of governments and private banks
Government Default and Private Credit
3
• After sovereign default, the flow of private credit comes to a halt
The Default-Private Credit Link
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Two potential stories for the above correlations:
Greek-style default:
financial distress in the government → banks are hurt because they hold government bonds → credit crunch
Irish-style default:
private banking crisis → government nationalizes (or bails out) banks → government is over-indebted, twin crisis follows
Can we distinguish between these two views?
Do they have different implications?
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-140.00%
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2011
EU Banks' Stock Returns and Exposure to PIGS BondsCAR of [(High Exposure to PIGS Bonds) - (Low Exposure to PIGS Bonds)] Portfolio
Ireland downgrade
Greek budget disclosed
Greek Bailout approved
Portuguese Bailout approvedIrish Bailout
agreed
Greek Bailout committed
Irish Bailout first press leaks
Greek budget cuts announced
Upon arrival of bad news, banks holding government bonds suffer…
A First Pass Assessment
Some preliminary support for Greek style default: financial distress in the government → banks are
hurt because they hold government bonds → credit crunch
Irish-style is also important, but let’s start with Greece A theory of Irish style default should still explain
why the government default triggers a sharp credit contraction
Two crucial questions: If government bonds are deadly, why do banks hold them? What about the government default decision?
10
Literature Background (I)11
Government default decision: Traditional literature on sovereign debt (see Eaton
and Fernandez 1995) assumes that government defaults can selectively discriminate between foreign and domestic bondholders.
In this theory, the cost of default is external punishment (e.g. exclusion from international financial markets).
In this theory, the government trades off the benefit from defaulting in terms of increasing current consumption, with the cost of being excluded from future borrowing (or trade).
Literature Background (II)12
Difficulties with the traditional theory: Observed exclusion is short lived. To rationalize
why countries default so infrequently need output cost (Arellano 2008).
Theoretical problems with the sustainability of penalties
Most important: In the traditional theory, perfect discrimination
implies that banks will be spared from default. That is, when the government defaults, domestic banks will be spared…
Some Observation13
Banks exposed to the domestic government are perceived to be in trouble when sovereign debt markets are in strain.
Markets do not expect (perfect) bailouts: Hard for the government to selectively default, Hard for the government to finance a bailout during a
default episode
We need a theory of Greek-style default
Investment and Default at t = 1 (III)
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• Let’s step back, for a moment: - In this theory, the government repays because banks hold public bonds - If banks did not hold government bonds, the government would always default! - Not necessarily sound to clean up the banking sector from bonds - Yet, bonds create fragility if a crisis is to occur
• What determines banks’ bond-holdings in the first place?
Banks’ Demand for Bonds (II)22
• Two comments:
- In our model, banks hold government bonds voluntarily, because these bonds allow them to make a carry trade
- In reality, other reasons as well: reserve requirements, central bank lending, financial repression (mostly in developing countries)
• Whatever the reason, the story goes through
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0.00
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1 - Small 2 3 4 - Large
Bondholdings by Size Quartile all years
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1 - Small 2 3 4 - Large
Bondholdings by Size Quartile during Sovereign Defaults years
Debt Sustainability (II)26
Debt sustainability requires:
Strong financial institutions: developed private financial markets help the government commit to repay. This increases the cost for the government of interfering
with intermediation
Important role of financial intermediaries (intermediate β): if banks are too small, or if firms can obtain funds at arm’s length, the government has no incentive to save the banking sector
Empirical Predictions27
Government default is followed by a drop in private credit. This drop is stronger if:
Banks hold more government bonds
Financial institutions are stronger
Ex-ante probability of default decreases as:
Banks hold more government bonds
Financial institutions are stronger
Data (New Paper)
Bank‐level data from BANKSCOPE dataset (Bureau van Dijk): Provides information on a broad range of bank characteristics BANKSCOPE suitable for international comparisons because data is harmonized
Crucial: BANKSCOPE reports banks’ holdings of public bonds However, does not say the nationality of the bonds We use IMF and EU stress test data to validate this information
Main sample: 4,723 banks in 151 countries; 25,132 bank‐year obs. Commercial, cooperative and savings banks account for 92% of our sample; investment
banks for 1.6%; rest are holdings, real estate, and other credit institutions Sample construction: start with full data; filter out duplicate records, banks with
negative value of assets, banks with total assets < $100,000, years < 1997 when coverage is less systematic. Get: 10,281 banks in 174 countries over 1998‐2010 (58,830 bank‐year observations)
Further impose: two consecutive years of data; data is available on size, leverage, risk taking, profitability, loans, Central Bank balances and other interbank ratiosIntro Data Hypotheses and Empirical Strategy
Results
Our Tests
1. Estimate banks’ demand for bondholdings (and of its various components)
Time-invariant (“normal times”) Bondholdings, both at bank and country level
Time-varying (“crisis times”) Bondholdings, both at bank and country level
2. Estimate effect of bondholdings (and of its various components) on banks’ changes in loans during default
Do banks more exposed to government bonds cut their loans more during default?
Which of the various components of bondholdings demand explain more of this variation?
Intro Data Hypotheses and Empirical Strategy
Results
Summary of Bondholdings Demand
Normal-time bondholdings account for 80% of total variation of bondholdings in our sample Largely explained by liquidity/insurance [risk taking (-), leverage (+),
fin dev (-)]
Default episodes alone explain 14% of time variation of bonds Banks take 16% more bonds during default Huge heterogeneity: esp. larger/more profitable banks load up on
government bonds during default Consistent with risk taking and/or government intervention through
moral suasion during crises
Next: do bondholdings affect changes in loans during default?
Intro Data Hypotheses and Empirical Strategy
Results
35
Bottom Line
Powerful feedback effects between banks and sovereign default risk: A government facing a weak domestic banking
sector faces a hard time borrowing, but.. Financial development will enhance fragility in case
of default Similar to the banking crises studied earlier
Additional implication: a banking crisis can lead to sovereign default risk. Links with Irish-style crises Banking crisis reduces incentive to repay and tax
revenues Government can try to bail out failed banks
36
International Contagion
Bolton and Jeanne (2012) use the previous mechanism to generate contagion effects across countries. International banks hold diversified sovereign bonds
portfolios Default in one country hurts banks in many country This triggers a recession across countries, in turn
increasing the likelihoods of additional government defaults
Ex-ante, countries issue too much debt because they do not internalize the contagion effect on other countries
40
Irish-style Bailouts
From Acharya, Drechsler and Schanbl (2011)
Imagine that a highly levered banking sector enters a financial crisis. Why would it makes sense for the government to bail it out? Answer is related to micro-frictions/externalities
This paper: the government might default to relieve the private sector from debt overhang problems For given taxes, the government dilutes existing
government bondholders, reducing the government’s creditowrthiness
This increases the probability of twin defaults when future shocks hit