We present a model of sovereign debt in which, contrary to conventional wisdom, government defaults are costly because they destroy the balance sheets of domestic banks. In our model, better financial institutions allow banks to be more leveraged, thereby making them more vulnerable to sovereign...

In a financial contracting model, we study the optimal debt structure to resolve financial distress. We show that a debt structure where two distinct debt classes co-exist – one class fully concentrated and with control rights upon default, the other dispersed and without control rights...