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The Sovereign-Bank Diabolic Loop and ESBies

Listed author(s):
  • Marcus K. Brunnermeier

    (Princeton University)

  • Luis Garicano

    (London School of Economics)

  • Philip R. Lane

    (Trinity College Dublin)

  • Marco Pagano

    (University of Naples Federico II and EIEF)

  • Ricardo Reis

    (Columbia University)

  • Tano Santos

    (Columbia Business School)

  • David Thesmar

    (HEC Paris)

  • Stijn Van Nieuwerburgh

    (New York University Stern Business School)

  • Dimitri Vayanos

    (London School of Economics)

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.

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File URL: http://www.eief.it/files/2016/06/wp-03-the-sovereign-bank-diabolic-loop-and-ecbies_.pdf
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Paper provided by Einaudi Institute for Economics and Finance (EIEF) in its series EIEF Working Papers Series with number 1603.

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Length: 14 pages
Date of creation: 2016
Date of revision: May 2016
Handle: RePEc:eie:wpaper:1603
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  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. Jakob von Weizsäcker & Jacques Delpla, 2011. "Eurobonds: The blue bond concept and its implications," Policy Contributions 509, Bruegel.
  4. Obstfeld, Maurice, 2013. "Finance at Center Stage: Some Lessons of the Euro Crisis," CEPR Discussion Papers 9415, C.E.P.R. Discussion Papers.
  5. 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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