Sovereign Default Risk and Banks in a Monetary Union

by Sabrina I. Pacifici on August 13, 2013

Sovereign Default Risk and Banks in a Monetary Union, Harald Uhlig, University of Chicago – Department of Economics. August 12, 2013 Becker Friedman Institute for Research in Economics Working Paper No. 2013-002

This paper seeks to understand the interplay between banks, bank regulation, sovereign default risk and central bank guarantees in a monetary union. I assume that banks can use sovereign bonds for repurchase agreements with a common central bank, and that their sovereign partially backs up any losses, should the banks not be able to repurchase the bonds. I argue that regulators in risky countries have an incentive to allow their banks to hold home risky bonds and risk defaults, while regulators in other “safe” countries will impose tighter regulation. As a result, governments in risky countries get to borrow more cheaply, effectively shifting the risk of some of the potential sovereign default losses on the common central bank.”

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