Sovereign Debt, Domestic Banks, and the Provision of Public Liquidity

This paper develops a model to study how a default can affect the domestic economy and the government's ability to provide liquidity. Banks that do not have good investment opportunities invest in public debt. After a default the government's ability to credibly issue debt is undermined. A scarcer supply of public debt makes banks substitute away from government securities to investments in their less productive projects. A quantitative analysis of the model for Argentina can generate a deep and persistent fall in output post-default, which induces repayment incentives to sustain significant levels of external public debt. We provide empirical support for the model's mechanism and use the model to analyze different policies that regulate banks' holdings of public debt.​