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The sovereign-bank diabolic loop and ESBies

Author

Listed:
  • Brunnermeier, Markus K.
  • Garicano, Luis
  • Lane, Philip R.
  • Pagano, Marco
  • Reis, Ricardo
  • Santos, Tano
  • Thesmar, David
  • Nieuwerburgh, Stijn Van
  • 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

  • Brunnermeier, Markus K. & Garicano, Luis & Lane, Philip R. & Pagano, Marco & Reis, Ricardo & Santos, Tano & Thesmar, David & Nieuwerburgh, Stijn Van & Vayanos, Dimitri, 2016. "The sovereign-bank diabolic loop and ESBies," LSE Research Online Documents on Economics 66429, London School of Economics and Political Science, LSE Library.
  • Handle: RePEc:ehl:lserod:66429
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    References listed on IDEAS

    as
    1. Farhi, Emmanuel & Tirole, Jean, 2015. "Deadly Embrace: Sovereign and Financial Balance Sheets Doom Loops," CEPR Discussion Papers 11024, C.E.P.R. Discussion Papers.
    2. Russell Cooper & Kalin Nikolov, 2013. "Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty," NBER Working Papers 19278, National Bureau of Economic Research, Inc.
    3. 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.
    4. Jakob von Weizsäcker & Jacques Delpla, 2011. "Eurobonds: The blue bond concept and its implications," Policy Contributions 509, Bruegel.
    5. Obstfeld, Maurice, 2013. "Finance at Center Stage: Some Lessons of the Euro Crisis," CEPR Discussion Papers 9415, C.E.P.R. Discussion Papers.
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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. Ari, Anil, 2018. "Sovereign risk and bank risk-taking," ESRB Working Paper Series 73, European Systemic Risk Board.
    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.

    More about this item

    Keywords

    ‘diabolic loop’; sovereign debt crisis; ESBies;

    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
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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