A theory of governance in sovereign lending

by Blanco, Alba

Governance and the role it plays in lending to sovereign nations emerged prirnarily as a redt of lenden' experience over the years. Although governance did not always play an integral part in sovereign lending, recently, for rasons which include past defaults as weU as the threat of future defaults, more and more attention has been focured on it. However, a theory d e f ~ g its place in sovereign lending is d lacking. Why is it that some banks choose to engage in govemance while othen do not? Why are some banks ready to delegate governance to multilateral institutions such as the World Bank and how do they make this decision? This diesis builds a theoretical model of governance in sovereign lending that explains the choices and the decision making process of banks involved in this type of lending. It models banks' governance decisions in both a single penod and a multiperiod sening where, in each setting, a bank is asnimed to have three govemance options, each with a different cos and effectiveness: delegation of govemance to a mulutateral agency, governance of the sovereign debtor by the bank icself or no governance. The bank's optimal choice is shown ro depend on a cos-benefit analysis of each option. The single period analysis is presented under the asasnimption of a single sovereign debtor with a risk averse and a risk neutral bank. Two sepante extensions of this model are also examlied, with two different borrower types and multiple sovereign borrowen. The single penod senhg is limiting in the sense that there is no role for defaulc penalties and reentry into the market, and hence no room for die sovereign borrower to build a reputation that might provide benefirs in subsequent periods. The multiperiod model adds these intertemporal linkages and aKempts to then determine the borrower's optimal repayment strategy in addition to a bank's optimal governance option. The analysis demonstrates that when a borrower reenten the market more chan once, rnaintaining its reputation becomes important: the reputation has intrinsic vaiue.