Sovereigns at Risk: A Dynamic Model of Sovereign Debt and Banking Leverage

Nuno Coimbra

Chapter in NBER book NBER International Seminar on Macroeconomics 2019 (2020), Kristin Forbes and Pierre-Olivier Gourinchas, organizers
Conference held June 27–28, 2019
Published in May 2020 by Elsevier, Journal of International Economics, volume 124
in NBER Book Series NBER International Seminar on Macroeconomics

This paper develops a dynamic model with heterogeneous investors and sovereign default to analyze the dynamic link between banking sector capitalization and sovereign bond yields. The banking sector is modelled as operating under a Value-at-Risk (VaR) constraint, which can bind occasionally. As default risk rises, the constraint may bind, generating a fall in demand for sovereign bonds that can be accompanied by a rise in the risk premium if other agents are more risk averse. In turn, the rise in risk premium leads to a feedback effect through debt accumulation dynamics and the probability of government default.

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Document Object Identifier (DOI): 10.1016/j.jinteco.2020.103298