Sovereign Defaults, Bank Runs, and Contagion

32 Pages Posted: 25 Sep 2014

See all articles by Stephan Luck

Stephan Luck

Federal Reserve Bank of New York

Paul Schempp

University of Cologne - Center for Macroeconomic Research (CMR); Max Planck Institute for Research on Collective Goods

Date Written: September 2014

Abstract

We provide a model that unifies the notion of self-fulfilling banking crises and sovereign debt crises. In this model, a bank run can be contagious by triggering a sovereign default, and vice versa. A deposit insurance scheme can eliminate the adverse equilibrium only if the government can repay its debt and credibly insure deposits irrespective of the performance of the financial sector. Moreover, we analyze how banking crises and sovereign defaults can be contagious across countries. We give conditions under which the implementation of a banking union is effective and costless. Finally, we discuss the current proposals for a banking union in the euro area and argue that it should be extended by a supranational Deposit Guarantee Scheme.

Keywords: bank run, financial crisis, sovereign default, vicious cycle, financial contagion, banking union, deposit insurance

JEL Classification: G21, G28, H81, H63

Suggested Citation

Luck, Stephan and Schempp, Paul, Sovereign Defaults, Bank Runs, and Contagion (September 2014). MPI Collective Goods Preprint, No. 2014/15, Available at SSRN: https://ssrn.com/abstract=2500798 or http://dx.doi.org/10.2139/ssrn.2500798

Stephan Luck

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

Paul Schempp (Contact Author)

University of Cologne - Center for Macroeconomic Research (CMR) ( email )

Cologne
Germany

Max Planck Institute for Research on Collective Goods ( email )

Kurt-Schumacher-Str. 10
D-53113 Bonn, 53113
Germany

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