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Government Debt And Banking Fragility: The Spreading Of Strategic Uncertainty

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  • Russell Cooper
  • Kalin Nikolov

Abstract

This article studies the interaction of government debt and financial markets. This interaction, termed a “diabolic loop,” is driven by government choice to bail out banks and the resulting incentives for banks to hold government debt instead of self‐insure through equity buffers. We highlight the role of bank equity issuance in determining whether the “diabolic loop” is a Nash equilibrium of the interaction between banks and the government. When equity is issued, no diabolic loop exists. In equilibrium, banks' rational expectations of a bailout ensure that no equity is issued and the sovereign‐bank loop is operative.

Suggested Citation

  • Russell Cooper & Kalin Nikolov, 2018. "Government Debt And Banking Fragility: The Spreading Of Strategic Uncertainty," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 59(4), pages 1905-1925, November.
  • Handle: RePEc:wly:iecrev:v:59:y:2018:i:4:p:1905-1925
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    File URL: https://doi.org/10.1111/iere.12323
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    References listed on IDEAS

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    1. Harald Uhlig, 2014. "Sovereign Default Risk and Banks in a Monetary Union," German Economic Review, Verein für Socialpolitik, vol. 15(1), pages 23-41, February.
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    3. Roch, Francisco & Uhlig, Harald, 2018. "The dynamics of sovereign debt crises and bailouts," Journal of International Economics, Elsevier, vol. 114(C), pages 1-13.
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    8. Russell Cooper & Hubert Kempf & Dan Peled, 2008. "Is It Is Or Is It Ain'T My Obligation? Regional Debt In A Fiscal Federation," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 49(4), pages 1469-1504, November.
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    More about this item

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • H12 - Public Economics - - Structure and Scope of Government - - - Crisis Management
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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