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The Sovereign-Bank Diabolic Loop and Esbies

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  • Thesmar, David

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  • Brunnermeier , Markus K
  • Garicano , Luis
  • Lane, Philip R
  • Pagano , Marco
  • Reis, Ricardo
  • Santos , Tano
  • Van Nieuwerburgh , Stijn
  • Vayanos , Dimitri

Abstract

We propose a simple model of the sovereign-bank diabolic loop, and establish four results. First, the diabolic loop can be avoided by restricting banks’ domestic sovereign exposures relative to their equity. Second, equity requirements can be lowered if banks only hold senior domestic sovereign debt. Third, such requirements shrink even further if banks only hold the senior tranche of an internationally diversified sovereign portfolio – known as ESBies in the euro-area context. Finally, ESBies generate more safe assets than domestic debt tranching alone; and, insofar as the diabolic loop is defused, the junior tranche generated by the securitization is itself risk-free.

Suggested Citation

  • Thesmar, David & Brunnermeier , Markus K & Garicano , Luis & Lane, Philip R & Pagano , Marco & Reis, Ricardo & Santos , Tano & Van Nieuwerburgh , Stijn & Vayanos , Dimitri, 2016. "The Sovereign-Bank Diabolic Loop and Esbies," HEC Research Papers Series 1133, HEC Paris.
  • Handle: RePEc:ebg:heccah:1133
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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. Carlo Altavilla & Marco Pagano & Saverio Simonelli, 2017. "Bank Exposures and Sovereign Stress Transmission," Review of Finance, European Finance Association, vol. 21(6), pages 2103-2139.
    3. Leonello, Agnese, 2018. "Government guarantees and the two-way feedback between banking and sovereign debt crises," Journal of Financial Economics, Elsevier, vol. 130(3), pages 592-619.
    4. 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.
    5. Jakob von Weizsäcker & Jacques Delpla, 2011. "Eurobonds- The blue bond concept and its implications," Policy Contributions 509, Bruegel.
    6. Obstfeld, Maurice, 2013. "Finance at Center Stage: Some Lessons of the Euro Crisis," CEPR Discussion Papers 9415, C.E.P.R. Discussion Papers.
    7. 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.
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    Cited by:

    1. Pierre-Olivier Gourinchas & Thomas Philippon & Dimitri Vayanos, 2017. "The Analytics of the Greek Crisis," NBER Macroeconomics Annual, University of Chicago Press, vol. 31(1), pages 1-81.
    2. Cutura, Jannic Alexander, 2018. "Debt holder monitoring and implicit guarantees: Did the BRRD improve market discipline?," SAFE Working Paper Series 232, Leibniz Institute for Financial Research SAFE.
    3. Orkun Saka, 2017. "Domestic banks as lightning rods? Home bias during the Eurozone crisis," LEQS – LSE 'Europe in Question' Discussion Paper Series 122, European Institute, LSE.

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    More about this item

    Keywords

    diabolic loop; sovereign debt crisis; government default; bank default; bailout; ESBies;
    All these keywords.

    JEL classification:

    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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