Debt Seniority and Sovereign Debt Crises

44 Pages Posted: 1 Aug 2018

See all articles by Anil Ari

Anil Ari

International Monetary Fund

Giancarlo Corsetti

University of Cambridge; University of Rome III - Department of Economics; Centre for Economic Policy Research (CEPR)

Luca Dedola

Bank of Italy; European Central Bank (ECB)

Date Written: May 2018


Is the seniority structure of sovereign debt neutral for a government's decision betweendefaulting and raising surpluses? In this paper, we address this question using a model ofdebt crises where a discretionary government endogenously chooses distortionary taxationand whether to apply an optimal haircut to bondholders. We show that when the size ofsenior tranches is small, a version of the Modigliani-Miller theorem holds: tranching justredistributes government revenues from junior to senior bondholders, while taxes andgovernment borrowing costs remain unchanged. However, as senior tranches becomesufficiently large, default costs on senior debt transpire into a stronger commitment to repaynot only the senior tranche, but also the junior one. We show that there is a lower thresholdfor senior bonds above which tranching can eliminate default on both junior and senior debt,and an upper threshold beyond which the government defaults also on senior debt.

Keywords: Debt crises; Sovereign default; Seniority; Eurobonds; Multiple equilibria; Self-fulfilling expectations, Debt crises, Sovereign default, Seniority, Eurobonds, Multiple equilibria, Self-fulfilling expectations, International Lending and Debt Problems, Asset Pricing

JEL Classification: F34, G12, H63

Suggested Citation

Ari, Anil and Corsetti, Giancarlo and Dedola, Luca, Debt Seniority and Sovereign Debt Crises (May 2018). IMF Working Paper No. 18/104, Available at SSRN:

Anil Ari (Contact Author)

International Monetary Fund ( email )

700 19th Street NW
Washington, DC 20431
United States

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Giancarlo Corsetti

University of Cambridge ( email )

University of Rome III - Department of Economics ( email )

via Ostiense 139
Rome, 00154
+39 06 5737 4056 (Phone)
+39 06 5737 4093 (Fax)

Centre for Economic Policy Research (CEPR)

United Kingdom

Luca Dedola

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314

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