Long term government debt, financial fragility, and sovereign default risk

We analyze the interaction between bank rescues, financial fragility and sovereign debt discounts. To that end we set up a model that contains balance sheet constrained financial intermediaries financing both capital expenditure of intermediate goods producers and government deficits. The financial intermediaries face the risk of a (partial) default of the government on its debt obligations due to the fact that there exists a maximum level of debt service that is politically feasible ("Fiscal Limit"). First we analyze the impact of a financial crisis, comparing the case of full credibility of government debt with the case of an endogenous sovereign debt discount. We find that the introduction of the default possibility does not in itself have an effect on the equilibrium outcome under the assumption of short term debt finance only. Interest rates on debt reflect higher default probabilities, but because all debt is short term, bank balance sheets are unaffected and no further negative amplification effects arise through the endogenous sovereign debt channel. This changes when long term government debt is introduced due to the impact of capital losses on bank balance sheets. We find that the equilibrium outcome significantly deteriorates with respect to the case where the government uses short term debt. Higher interest rates on new debt lead to capital losses on banks' holding of existing long term government debt. The associated increase in credit tightness leads to a strongly negative amplification effect, significantly increasing the output losses, recession duration and declines in investment after a financial crisis. This raises potential conflicting macroeconomic influences of a debt financed recapitalization of banks after a financial crisis. We investigate the case where the government tackles the financial crisis by announcing a recapitalization of the financial system to occur 4 quarters after announcement. Under the parameter values chosen, the positive effects from an anticipated capital injection dominate the effects of the associated increase in sovereign default risk.