Sovereign default, domestic banks and financial institutions,” Economics Working Papers 1170

We study the link between sovereign default, domestic credit markets and financial institutions, both theoretically and empirically. We build a model where public default weakens the balance sheets of banks because they hold public bonds, causing a decline in private credit. We find that stronger financial institutions boost the cost of default by amplifying balance sheet effects. This yields a novel complementarity between public debt and domestic credit markets, where the latter sustain the former by increasing the cost of default. We uncover three novel facts that are consistent with our model’s predictions. First, public defaults are followed by large contractions in private credit. Second, these contractions are more severe in countries where banks hold more public debt and financial institutions are stronger. Third, in these same countries the probability of default is lower