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Domestic debt restructurings impose direct costs on the local financial system making them inherently more complex to design than external debt restructurings. These costs are due to the existence of a typically strong nexus between sovereign and financial institutions (especially banks), which during episodes of sovereign stress could affect the balance sheet (both asset and liability side) and income of those institutions. Since the total cost of recapitalization of banks and safeguarding financial stability is likely to be an increasing function of haircut imposed on debt holders, beyond a threshold value of such haircut the marginal (and potentially even total) net debt relief accrued to the budget may become negative. This may also cause irreparable harm to the financial sector, potentially causing a crisis. Calibrating the parameters (most notably, the haircut) of a domestic debt restructuring to help avoid a financial crisis is important because debt restructurings accompanied by banking crises are historically associated with larger output losses.

Suggested reading:

International Monetary Fund, 2021. “,” IMF Policy Paper, December.

Das, Udaibir, et el., 2010. "," IMF Working Paper 10/280, December.

Grigorian, David A., 2023. “,” IMF Working Paper 23/24, February.

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