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Austerity to save the banks


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Presentation from ADEMU Fiscal Risk and Public Sector Balance Sheets Conference at the University of Bonn, July 6-7

Published in: Economy & Finance
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Austerity to save the banks

  1. 1. Comments on: Austerity to save banks? A qualitative model of sovereign default with endogenous default costs and a financial sector by Dominik Thaler (Bank of Spain) Florian Buck (German Ministry of Finance) ADEMU Workshop – Bonn, July 6-7, 2017
  2. 2. 2 The paper in a nutshell: why do governments repay sovereign debt? Model of strategic sovereign default • explains output costs AND exclusion • highlights stabilizing effect of home bias [Gennaioli et al., 2014; Engler & Große Steffen, 2016]
  3. 3. 3 Model mechanism: Strategic default in a banking economy (Ricardian) Household Smart Bank Firm Benevolent Government External debt Deposits Loans Loans Deposits Bonds Equity Bonds Bonds Direct lending Financial friction Lump-sum tax less efficient
  4. 4. 4 Model mechanism: trading-off net cost and benefits of default When the government defaults on its debt… • Output costs • Banks' equity drops & leverage constraint becomes binding • Banks provide less credit -> deposit-loan spread increases • Households provide less-efficient direct capital to firms • Lower capital, less production and income for household • External exclusion • Government could raise external debt that would ow into inefficient direct investment -> Foreign debt capacity shrinks • Only when equity has risen again, external lending becomes optimal again
  5. 5. 5 Discussing the key assumption: Superiority of bank orientation due to financial frictions • What would be the first best allocation in the model? • Maximizing intermediated lending • Reason: Inefficiencies arise when banking sector is constrained by leverage ratio • Optimal policy response • What will happen, if bank bailout is allowed? • Empirical discussion of main channel • Prediction: Households provide more direct lending in times of default • Reason: Substitution due to constrained banking
  6. 6. 6 Discussing the role of the government: benevolent, omniscient, but limited? • The toolkit of the government • Lump sum taxes and bonds (to finance fixed expenditures) • Strategic default choice: full repayment or full default ⨻ What will happen with extra capital requ. for bonds? • Discussion: partial default (Sturzenegger&Zettelmeyer, 2008) • Inefficient bond holding restriction ex-ante • Banks would not invest into bonds at all • Reason #1: World interest rate < return on domestic capital • Reason #2: Bonds are risky • Minor: How does austerity cost enter into the model?
  7. 7. 7 Policy application: Is the model mechanism idiosyncratic to Greece? • Paper claims: “Greece seems an ideal match for the model” (p. 26) – Are Italy, Portugal and Spain similar examples? What about calibrating Cyprus? – Are the model predictions consistent with patterns in less developed countries? • Paper argues: “modeling was guided by the European debt crisis“ (p. 27) – Institutional environment in EMU: What will happen, if we introduce the ECB (e.g. provision of ELA-credit) – National banking systems are interconnected -> default costs abroad and feedback effects for sovereign
  8. 8. 8 Bank exposure and sovereign risk: Consistency with correlation of CDS and exposure?
  9. 9. 9 Bank exposure and sovereign risk: Disciplinary device vs. diabolic loop Two competing hypotheses in literature • Sovereign Default View: Bank exposure can act as a disciplinary device for the sovereign. – Prediction: Default risk falls with rising exposure – Key: Adverse effects on domestic bank’s balance sheets – This paper; Gennaioli et al., 2014; Engler and Große Steffen, 2016 • Sovereign-Bank Nexus View: diabolic loop of risk contagion between sovereign and domestic banking sector. – Prediction: Default risk rises with rising exposure – Key: Spillovers from banking sector: credit supply & bailout channel; from sovereign: portfolio, collateral, guarantee and sovereign rating channel – Brunnermeier et al., 2016; Kiyotaki &Moore, 2005; Arezki et al., 2011
  10. 10. 10 Bank exposure and sovereign risk: Main channels responsible for diabolic loop transmission
  11. 11. 11 Bank exposure and sovereign risk: Idea of an empirical exercise The role of state dependency (Podstawski&Velinov, 2016) • Diabolic loop mechanism particularly pronounced during times of financial distress – Destabilizing effect from bank exposure in countries hardest hit by the crisis (SPA, ITA, POR) • Bank exposure stronger disciplinary effect during times of fiscal stress – Stabilizing effect from bank exposure in countries less hit by the crisis (FRA, DEU, NLD)
  12. 12. 12 Conclusion: Austerity to save banks • Sovereign-financial nexus very timely topic in sovereign debt theory/empirics – Author has set up important questions for regulators and policy-makers – Main contribution: endogenising output and exclusion cost – Calibration of empirically plausible magnitudes of the consequences of default for Greek data • Policy Application – Careful discussion: Is banks‘ home bias good or bad for public debt sustainability?