Financial fragility, sovereign default risk and the limits to commercial bank bail-outs

We show that with intertwined weak banks and weak sovereigns, bank recapitalizations become much less effective. We construct a DSGE model with leverage constrained banks lending to firms and holding domestic government bonds. Bond prices reflect endogenously generated sovereign risk. This introduces a negative amplification cycle: after a credit crisis output losses increase more because higher interest rates trigger lower bond prices and subsequent losses at banks. This further tightens bank leverage constraints, and causes interest rates to rise further. Also bank recapitalizations are then much less effective. Recaps involve swaps of newly issued sovereign bonds for bank equity, the new debt increases sovereign debt discounts, leading to capital losses for the banks on their holdings of sovereign debt that (partially) offset the impact of the recapitalization. The favorable macroeconomic effects of bank recaps on the recovery after a financial crisis are correspondingly lower.