Abstract for: Modelling Sovereign Debt Induced Banking Crises: Theory, Application and Policy Conundrums

The paper examines the relationship between sovereign debt dynamics and the stability of financial institutions using a system dynamics framework. It also explores the effectiveness of various policy options aimed at restoring stability after severe macrofinancial shocks. The model incorporates three main agents: banks, a central government and a rating agency. The banks and the central government are assumed to be boundedly rational and backward looking interacting via both the local and international capital markets. Further, the credit rating agency is assumed to be rational and forward-looking. The framework identifies the transmission mechanisms linking sovereign debt and financial sector crises when the above three agents interact over time. Although the calibrated model is informed by Jamaican data and the debt situation which has prevailed there since the global financial crisis, the model provides a framework for the consideration of sovereign debt crises in other countries. The model does well in developing a causality driven approach to explain the reasons behind increasingly unsustainable debt-deficit dynamics and how these imbalances can spill-over into the banking sector leading to increased financial fragility. The paper closes with a discussion on the usefulness of this approach in informing regulatory reform within the banking sector.