Abstract Anand

We develop an equilibrium model of bank risk-taking in the presence of strategic sovereign default risk. Domestic banks can either invest in real projects or purchase government bonds. While an increase in purchases of government bonds crowds out profitable investment, it nevertheless improves the government's incentives to repay and reduces the bond price. However, since banks are price-takers in bond markets, this gives rise to a pecuniary externality. We analyze the welfare consequences of the externality and relate our  findings to the debate on the eficacy of recent policy proposals for regulating banks' sovereign debt exposures.

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