Working Paper

The 2012 Eurozone Crisis and the ECB’s OMT Program: A Debt-Overhang Banking and Sovereign Crisis Interpretation

Abstract: This paper develops a model to interpret the 2012 eurozone crisis and the ECB?s policy response. In the model, bank lending is distorted by debt overhang, banks hold sovereign bonds, and the government guarantees the bailout of bank creditors. A self-fulfilling pessimistic view of the economy can trigger a banking and sovereign crisis: with pessimistic economic expectations, the value of sovereign bonds declines, the bank risk of default rises, and the debt overhang distortion worsens; this leads to a contraction in bank lending and to a decline in economic activity, which confi rms the initial pessimistic expectations. A commitment by the central bank to purchase the sovereign bonds at pre-crisis market spreads manages to eliminate the crisis equilibrium.

Keywords: Debt overhang; multiple equilibria; self-fulfilling expectations; financial fragility; systemic risk;

JEL Classification: G01;

https://doi.org/10.26509/frbc-wp-201509

Bibliographic Information

Provider: Federal Reserve Bank of Cleveland

Part of Series: Working Papers (Old Series)

Publication Date: 2015-06-02

Number: 1509