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The Sovereign-Bank Diabolic Loop and Esbies

Author

Listed:
  • Markus Brunnermeier
  • Luis Garicano
  • Philip Lane
  • Marco Pagano
  • Ricardo Reis

    (UFRGS - Universidade Federal do Rio Grande do Sul [Porto Alegre – Brasil] = Federal University of Rio Grande do Sul [Porto Alegre – Brazil])

  • Tano Santos
  • David Thesmar

    (GREGH - Groupement de Recherche et d'Etudes en Gestion à HEC - HEC Paris - Ecole des Hautes Etudes Commerciales - CNRS - Centre National de la Recherche Scientifique)

  • Stijn van Nieuwerburgh
  • Dimitri Vayanos

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

  • Markus Brunnermeier & Luis Garicano & Philip Lane & Marco Pagano & Ricardo Reis & Tano Santos & David Thesmar & Stijn van Nieuwerburgh & Dimitri Vayanos, 2016. "The Sovereign-Bank Diabolic Loop and Esbies," Working Papers hal-01993425, HAL.
    • Handle: RePEc:hal:wpaper:hal-01993425
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    JEL classification:

    • J1 - Labor and Demographic Economics - - Demographic Economics

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