Modeling guarantees, over-indebtedness and financial crises in an open economy

This work develops a simple framework to analyse how financial intermediaries' balance sheet problems combined with financial guarantees make an economy more vulnerable to financial crises. A 'double default' problem - that is, the default of financial intermediaries on their debt repayments and of the government on its guarantees to bailout intermediaries' losses - is modelled in this study. The possibility of multiple equilibria, including a crisis equilibrium where the government is not able or willing to honor its guarantees towards the domestic financial sector, arises from the interplay of all the above elements: financial intermediaries' level of indebtedness, government implicit guarantees and high-risk creditors' lending. This work also produces predictions concerning the vulnerability to a financial crisis: multiple equilibria are possible only in certain ranges of the fundamentals.