Sovereign debt default and banking in a currency union

This paper analyzes the role of banking in the transmission of sovereign debt default within a currency union. We build a 2-country (core and periphery) new-Keynesian model with an endogenous possibility of default on the periphery public debt. We introduce alternative banking representations, going from full integration to fragmentation. We calibrate the model on euro area data and show that the best fit to empirical data arises when we introduce some degree of fragmentation. However, we observe that a well integrated banking sector would reduce the negative consequences of default at the EA aggregated level and limit the welfare cost of stabilizing policies.