A game theoretical approach to the international debt overhang

We consider an international financial problem called debt overhang, by which we mean a situation where a sovereign country has borrowed money from foreign banks and has been unable to fulfill the scheduled repayments for some period. The problem is formulated as a noncooperative game with n lender banks as players where each decides either to sell its loan exposure to the debtor country at the present price of debt on the secondary market, or to wait and keep its exposure. This game has many pure and mixed strategy Nash equilibria. We show, however, that in any Nash equilibrium, the resulting secondary market price remains almost the same as the present price for a large number of banks. We also obtain the comparative statics result that in a mixed strategy equilibrium, a bank with a smaller loan exposure has a greater tendency to sell than one with a larger loan exposure. We discuss the implications of these results for the functioning of the secondary market and the resolution of debt overhang.