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 Board of Governors of the Federal Reserve SystemInternational Finance Discussion PapersNumber 1067December 2012Banks, Sovereign Debt and the International Transmission of Business CyclesLuca Guerrieri, Matteo Iacoviello, and Raoul MinettiNOTE: International Finance Discussion Papers are preliminary materials circulated tostimulate discussion and critical comment. References in publications to InternationalFinance Discussion Papers (other than an acknowledgment that the writer has had accessto unpublished material) should be cleared with the author or authors. Recent IFDPs areavailable on the Web at ww.federalreserve.gov/pubs/ifdp/. This paper can bedownloaded without charge from Social Science Research Network electronic library athttp://www.sssrn.com.
 
Banks, Sovereign Debt andthe International Transmission of Business Cycles
Luca GuerrieriFederal Reserve BoardMatteo IacovielloFederal Reserve BoardRaoul Minetti
Michigan State UniversityDecember 2012
Abstract
This paper studies the international propagation of sovereign debt default. We posit a two-country economy where capital constrained banks grant loans to firms and invest in bonds issuedby the domestic and the foreign government. The model economy is calibrated to data from Europe,with the two countries representing the Periphery (Greece, Italy, Portugal and Spain) and the Core,respectively. Large contractionary shocks in the Periphery trigger sovereign default. We find sizablespillover effects of default from Periphery to the Core through a drop in the volume of credit extendedby the banking sector.
JEL Classification: E44, F34, G15Keywords: Sovereign Default, Spillover Effects, DSGE Model, Banks.
Corresponding author. Department of Economics, Michigan State University. E-mail: minetti@msu.edu. Phone:+1-517-355-7349. Address: MSU Department of Economics, Marshall-Adams Hall, 486 W Circle Dr. Rm 110, EastLansing, MI 48824. The views expressed in this paper are solely the responsibility of the authors and should not beinterpreted as reflecting the views of the Board of Governors of the Federal Reserve System, or of any other personassociated with the Federal Reserve System. Replication codes and an Appendix containing detailed derivations areavailable from the authors upon request.
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1 Introduction
In the last fifteen years, following the introduction of the euro and the resulting elimination of exchangerate risk among euro area members, European banks have increasingly, “happily owned regional, ratherthan merely national, government bond portfolios” (The Economist, 2012). In particular, banks of thecore European countries (e.g., France and Germany) have turned into major holders of the sovereigndebt of periphery countries, such as Greece, Italy, Portugal and Spain. For instance, combining datafrom the Bank for International Settlements with data from the Bank of France reveals that in thelast quarter of 2009, just before the outbreak of the eurozone sovereign debt crisis, the ratio of Frenchbanks’ holdings of Periphery’s sovereign debt over their holdings of French government debt equaled56 percent, up from 19 percent in the first quarter of 2005. Figure 1 plots various ratios for Frenchbanks’ holdings of Periphery’s sovereign debt from the first quarter of 2005 to the third quarter of 2011.
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The figure shows a dramatic increase in the holdings of Periphery sovereign debt by Frenchbanks, whether these are normalized by banks’ total assets, their holdings of French government debtor by the total sovereign debt of Periphery countries.
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During the current sovereign debt crisis in Europe, the large holdings of government bondsaccumulated in recent years have significantly exposed European banks to the default risk of peripherycountries. This has been exacerbated by the fact that, as shown by the restructuring of Greek sovereigndebt in March 2012, banks and other private investors are treated as junior creditors relative to officialinvestors (e.g., the central banks of the Eurosystem) during sovereign debt restructurings.
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Europeanbanks have thus suffered from a sizable erosion of their capitalization and a severe difficulty to tapwholesale funding and interbank markets. Allegedly, this has resulted, in turn, into reduced abilityand propensity to extend credit to firms.The propagation of sovereign default to the banking sector and, ultimately, to the corporatesector poses challenges that have been largely unexplored, thus far. A first question regards themagnitude of the possible effects. How large can a bank credit crunch induced by a sovereign debt crisisbe and how important the international spillovers? Second, how does the degree of banks’ exposure
1
We choose data for France since analogous data for German banks are available only starting in 2010Q4.
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The holdings of Belgian, Italian and Spanish government debt exceeded the tier 1 capital of banks in the threecountries and 50 percent of the tier capital of banks in France and Germany (see Shambaugh, 2012).
3
The restructuring of Greek debt in March 2012 involved bonds for a total value of about 199 billion Euros. Theexchange of new bonds for old ones reduced the face value of bonds by almost 55 percent.
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