This paper explores the effect of macroprudential policies on bank balance sheets,
sovereign default risk, aggregate fluctuations and welfare. We build a model of defaultable
sovereign debt that incorporates endogenous production and a banking sector with a rich
balance sheet. The model captures the observed regularities on bank credit, bank holdings
of sovereign bonds and the cyclical properties of sovereign bonds and their spreads. A
sovereign default amplifies the business cycle since the default reduces the value of bank …

This paper explores the role of bank balance sheets, sovereign default risk, and capital
adequacy requirements in amplifying aggregate fluctuations. The paper, first, proposes a
unified model of defaultable sovereign debt and bank balance sheets to capture regularities
on bank credit to firms, banks' holdings of sovereign bonds, and the behavior of sovereign
debt and default. The model captures the procyclical bank credit and countercyclical bank
holdings of sovereign bonds. Since the sovereign defaults indiscriminately, bank losses due …