K.U.Leuven - Departement toegepaste economische wetenschappen
DTEW Research Report 09616 pages:1-19
In this paper, we examine the role that institutions may play in enabling banks to write contracts whereby sovereign debt is not forgiven ex post. Our model provides a rationale for the emergence of a centralized forum for debt renegotiation, such as the London Club as well as for bank syndicates. These bank syndicates arise as part of a pre-commitment device rather than risk sharing. We propose a debt contract under which, only involuntary default is forgiven ex post. Our main findings are that under this contract, renegotiations take place only after involuntary default and debt forgiveness after voluntary (strategic) default is avoided. When voluntary default occurs, access to the credit market is denied only for a limited number of periods, rather than forever. In contrast to a voluntary default, involuntary default is renegotiated immediately.