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Government debt and banking fragility: the spreading of strategic uncertainty

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  • Nikolov, Kalin
  • Cooper, Russell

Abstract

This paper 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 rather than 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. JEL Classification: G01, G28, E44

Suggested Citation

  • Nikolov, Kalin & Cooper, Russell, 2018. "Government debt and banking fragility: the spreading of strategic uncertainty," Working Paper Series 2195, European Central Bank.
  • Handle: RePEc:ecb:ecbwps:20182195
    Note: 288883
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    References listed on IDEAS

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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    sovereign-banking loop; sovereign default;

    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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