Guarantees, transparency and the interdependency between sovereign and bank default risk

Abstract

Bank debt guarantees have traditionally been viewed as costless measures to prevent bank runs. However, as recent experiences in some European countries have demonstrated, guarantees may link the coordination problems of bank and sovereign creditors and induce a functional interdependence between the likelihoods of a government default and bank illiquidity. Employing a global-game approach, we model this link, showing the existence and uniqueness of the joint equilibrium and derive its comparative statics properties. In equilibrium, the guarantee reduces the probability of a bank run, while it increases the probability of a sovereign default. The latter erodes the guarantee’s credibility and thus its effectiveness ex ante. By setting the guarantee optimally, the government balances these two effects in order to minimize expected costs of crises. Our results show that the optimal guarantee has clear-cut welfare gains which are enhanced through policies that promote greater balance sheet transparency.