Country risk, bank involvement, and the risk premium charged in the international financial market

The goal of this dissertation is to analyze the interaction between commercial banks and sovereign borrowers in the context of the developments of the debt crisis.; The risk associated with sovereign lending stems from the fact that a country may turn out to be unable or unwilling to adhere to its commitments as specified in loan contracts. The lack of enforceability and well-defined mechanism to settle disputes between debtors and creditors puts commercial banks at disadvantage compared with their position in a domestic setting. Therefore, sovereign borrowers have a strong leverage in debt negotiation.; There are large variations in powers and traits between participants in the international lending market. Therefore, interactions between different parties do not always yield unique outcomes.; The involvement of a bank with its clients may influence its reaction to payment difficulties faced by such clients. To handle this issue, I differentiated between two groups of banks; old banks and new banks. Both groups compete to attract new clients. However, new banks may not have incentive to extend their resources to a stressed debtor that has been dealing with old lenders. Therefore, heavily indebted countries have to deal with their original creditors.; Extending more resources to a particular client increases the bank exposure. Therefore, under normal circumstances, an old bank will charge an old client higher risk premium than the risk premium that would be charged to a new client with the same risk.; The size of resources already extended to a particular client determines the reaction of a bank toward a troubled old client. If the old client is a minor client, its default will not have strong effect on the bank's value. Therefore, the bank may not intervene to prevent such a default. However, a default by a major client will dramatically affect the bank's value. Therefore, the bank will stand by its major clients in case of a crisis. In its effort to rescue a major old client, the bank may soften the lending conditions and extend new loans at an interest rate that is lower than the interest rate on old loans.