Abstract
This paper focuses on the relationship between the financial system and sovereign debt crises by analyzing sovereign support to banks and banks' resulting exposure to the bonds issued by weak sovereigns. We construct an agent-based network model of an artificial financial system allowing us to analyze the effects of state support on systemic stability and the feedback loops of risk transfer back into the financial system.
The model is tested with various parameter settings in Monte Carlo simulations. Our analyses yield the following key results: first, in the short term, all the support measures improve systemic stability.
Second, in the longer run, there are settings which mitigate the systemic crisis and settings which contribute to systemic breakdown. Finally, there are differences among the effects of the different types of support measures.
While bailouts and recapitalization are the most efficient types of support type and execution of guarantees is still a viable solution, the results of liquidity measures such as asset relief or provision of funding liquidity are significantly worse.