Sovereign Risk and Bank Balance Sheets: The Role of Macroprudential Policies

This paper explores the role of bank balance sheets, sovereign default risk, and capital adequacy requirements in amplifying aggregate fluctuations. The paper, first, proposes a unified model of defaultable sovereign debt and bank balance sheets to capture regularities on bank credit to firms, banks' holdings of sovereign bonds, and the behavior of sovereign debt and default. The model captures the procyclical bank credit and countercyclical bank holdings of sovereign bonds. Since the sovereign defaults indiscriminately, bank losses due to a default hampers its lending to firms, thereby, generating an endogenous cost of default. The paper then conducts counterfactual policy experiments in line with Basel III. Our preliminary findings suggest that the introduction of leverage ratios is superior to increasing the capital requirement on risk weighted assets where sovereign bonds are assigned a zero weight.