was formed, but collapsed during the 2008-2009 crisis. They find that there is a link between core EMU banks’ borrowing from FIN and their lending to GIIPS during the pre-crisis period. This is as if the banks intermediated loans to the peripheral EMU. They do not find such a link for banks in different regions.<sup>7</sup> It is interesting that both the lending from FIN to the core EMU banks and lending from the core EMU banks to GIIPS collapsed during the crisis. This phenomenon could be explained by an increase in risk aversion of all lenders during this time (Guiso et al. (2013)), and a perceived higher default risk, particularly of GIIPS countries. Higher risk aversion and higher default risk would cause capital to retrench. Currency risk during the crisis might have become secondary, and might have been overshadowed by these factors.

# **3. Model**

We build a three-country, two-asset model to formalize our theory. The three countries are Periphery (denoted P), Core (denoted C) and Outsider (denoted O). P and C share the same currency (euros) while O uses dollars. The two assets are Periphery bonds and Core bonds, issued in euros. P only issues its Periphery bonds, and is assumed not to hold Core bonds. C can hold Periphery bonds, and issue its Core bonds. O has a choice of holding Periphery bonds and Core bonds. We also assume that the nominal bonds’ returns are state contingent: they depend on the output realization.

We assume that country P does not hold Core bonds. This assumption not only makes the model more tractable, but also is aligned with the empirical evidence. It allows us to imitate the borrowing nature of the periphery countries since the inception of the euro. Therefore, we are able to focus on the competition between the Core and the Outsider lenders over the Periphery debt and hence analyze the currency risk and business cycle channels with more clarity. Similarly, we do not allow the outside country to issue debt, as it does not contribute to the answering of the question at hand.

In each of the three economies, households provide labor and consume tradable and non-tradable goods. Firms produce non-tradable goods, and return profit to households. Households transfer wealth across time by holding or issuing bonds. While the country-specific non-tradable good is produced using labor, for simplicity, we assume that there is a single tradable good and each country receives an endowment of this good according to a country-specific stochastic process. The non-tradable goods’ prices are sticky, while the tradable good’s price is flexible. As a standard convention in the New Keynesian models, nominal rigidities in the non-tradable sector are modeled by dividing the sector into perfectly competitive retailers and monopolistically competitive intermediate good producers. In addition, in the model we assign Periphery and Core a higher discount rate to generate their borrowing from the Outsider in the equilibrium.

# _3.1. Notation_

To be clear from the beginning, let us go through some of the key notation used in the paper. Superscripts P, C, and O denote country P (Periphery), C (Core), and O (Outsider).

> 7Refer to Hale and Obstfeld (2016) for more detailed analysis with different data sources.

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