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The Bright Side of the Doom Loop: Banks Exposure and Default Incentives

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  • Luis Rojas
  • Dominik Thaler

Abstract

The feedback loop between sovereign and financial sector solvency has been identified as a key driver of the European debt crisis and has motivated an array of policy proposals. We revisit this “doom-loop” focusing on the government’s incentives to default. To this end we present a simple 3-period model with strategic sovereign default where debt is held by domestic banks and foreign investors. The government maximizes domestic welfare, and thus the temptation to default increases in foreign debt. Importantly, the costs of default arise endogenously from the damage default causes to domestic banks’ balance sheets. Domestically held debt thus serves a commitment device for the government. We show that two policy prescriptions that have emerged in this literature – lower exposure of banks to domestic sovereign debt or a commitment not to bailout banks – can backfire, as default incentives depend not just on the quantity of debt but also on who holds the debt. By contrast, allowing banks to buy additional sovereign debt in times of sovereign distress can rule out the doom loop.

Suggested Citation

  • Luis Rojas & Dominik Thaler, 2020. "The Bright Side of the Doom Loop: Banks Exposure and Default Incentives," Working Papers 1143, Barcelona Graduate School of Economics.
  • Handle: RePEc:bge:wpaper:1143
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    References listed on IDEAS

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    1. 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.
    2. Pablo D'Erasmo & Bora Durdu & Emine Boz, 2014. "Sovereign Risk and Bank Balance Sheets: The Role of Macroprudential Policies," 2014 Meeting Papers 641, Society for Economic Dynamics.
    3. Nicola Gennaioli & Alberto Martin & Stefano Rossi, 2014. "Sovereign Default, Domestic Banks, and Financial Institutions," Journal of Finance, American Finance Association, vol. 69(2), pages 819-866, April.
    4. Diego J. Perez, 2015. "Sovereign Debt, Domestic Banks and the Provision of Public Liquidity," Discussion Papers 15-016, Stanford Institute for Economic Policy Research.
    5. Emmanuel Farhi & Jean Tirole, 2018. "Deadly Embrace: Sovereign and Financial Balance Sheets Doom Loops," Review of Economic Studies, Oxford University Press, vol. 85(3), pages 1781-1823.
    6. Sosa-Padilla, César, 2018. "Sovereign defaults and banking crises," Journal of Monetary Economics, Elsevier, vol. 99(C), pages 88-105.
    7. Brutti, Filippo, 2011. "Sovereign defaults and liquidity crises," Journal of International Economics, Elsevier, vol. 84(1), pages 65-72, May.
    8. Engler, Philipp & Große Steffen, Christoph, 2016. "Sovereign risk, interbank freezes, and aggregate fluctuations," European Economic Review, Elsevier, vol. 87(C), pages 34-61.
    9. Leonello, Agnese, 2017. "Government guarantees and the bank-sovereign nexus," Research Bulletin, European Central Bank, vol. 35.
    10. repec:ecb:ecbrbu:2017:0035:1 is not listed on IDEAS
    11. Viral Acharya & Itamar Drechsler & Philipp Schnabl, 2014. "A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk," Journal of Finance, American Finance Association, vol. 69(6), pages 2689-2739, December.
    12. Messori, Marcello & Micossi, Stefano, 2018. "Counterproductive Proposals on Euro Area Reform by French and German Economists," CEPS Papers 13438, Centre for European Policy Studies.
    13. Neele Balke, 2018. "The Employment Cost of Sovereign Default," 2018 Meeting Papers 1256, Society for Economic Dynamics.
    14. Dominik Thaler, 2018. "Sovereign default, domestic banks and exclusion from international capital markets," Working Papers 1824, Banco de España;Working Papers Homepage.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    sovereign default; bailout; doom loop; self-fulfilling crises;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems

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