Note: The Discussion Papers in this series are prepared by members of the Department of Economics, University of Essex, for private circulation to interested readers. They often represent preliminary reports on work in progress and should therefore be neither quoted nor referred to in published work without the written consent of the author. Collateral, liquidity and debt sustainability ∗

Note: This Working Paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB This paper studies the bank-sovereign link in a dynamic stochastic general equilibrium set-up with strategic default on public debt. Heterogeneous banks give rise to an interbank market where government bonds are used as collateral. A default penalty arises from a breakdown of interbank intermediation that induces a credit crunch. Government borrowing under limited commitment is costly ex ante as bank funding conditions tighten when the quality of collateral drops. This lowers the penalty from an interbank freeze and feeds back into default risk. The arising amplication mechanism propagates aggregate shocks to the macroeconomy. The model is calibrated using Spanish data and is capable of reproducing key business cycle statistics alongside stylized facts during the European sovereign debt crisis.