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Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty

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  • Russell Cooper
  • Kalin Nikolov

Abstract

This paper studies the interaction of government debt and financial markets. Both markets are fragile: excessively responsive to fundamentals and prone to strategic uncertainty. 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 to self-insure through equity buffers. We provide conditions such that the ‘diabolic loop’ is a Nash Equilibrium of the interaction between banks and the government. Instability originates in debt markets and is channeled to financial arrangements, and then back again. The analysis highlights the critical role of bank equity for the existence of a diabolic loop. 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 operates.

Suggested Citation

  • 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.
  • Handle: RePEc:nbr:nberwo:19278
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    References listed on IDEAS

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    1. Harald Uhlig, 2014. "Sovereign Default Risk and Banks in a Monetary Union," German Economic Review, Verein für Socialpolitik, vol. 15(1), pages 23-41, February.
    2. Viral V. Acharya & Tanju Yorulmazer, 2008. "Cash-in-the-Market Pricing and Optimal Resolution of Bank Failures," Review of Financial Studies, Society for Financial Studies, vol. 21(6), pages 2705-2742, November.
    3. Nicola Gennaioli & Alberto Martin & Stefano Rossi, 2014. "Sovereign Default, Domestic Banks, and Financial Institutions," Journal of Finance, American Finance Association, vol. 69(2), pages 819-866, April.
    4. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
    5. Calvo, Guillermo A, 1988. "Servicing the Public Debt: The Role of Expectations," American Economic Review, American Economic Association, vol. 78(4), pages 647-661, September.
    6. Russell Cooper, 2012. "Debt Fragility and Bailouts," NBER Working Papers 18377, National Bureau of Economic Research, Inc.
    7. Acharya, Viral V. & Steffen, Sascha, 2015. "The “greatest” carry trade ever? Understanding eurozone bank risks," Journal of Financial Economics, Elsevier, vol. 115(2), pages 215-236.
    8. Jonathan Eaton & Mark Gersovitz, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Oxford University Press, vol. 48(2), pages 289-309.
    9. Harold L. Cole & Timothy J. Kehoe, 2000. "Self-Fulfilling Debt Crises," Review of Economic Studies, Oxford University Press, vol. 67(1), pages 91-116.
    10. Francisco Roch & Harald Uhlig, 2016. "The Dynamics of Sovereign Debt Crises and Bailouts," IMF Working Papers 16/136, International Monetary Fund.
    11. Russell Cooper & Hubert Kempf, 2013. "Deposit Insurance and Orderly Liquidation without Commitment: Can we Sleep Well?," NBER Working Papers 19132, National Bureau of Economic Research, Inc.
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    Citations

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    Cited by:

    1. Neyer, Ulrike & Sterzel, André, 2017. "Capital requirements for government bonds: Implications for bank behaviour and financial stability," DICE Discussion Papers 275, University of Düsseldorf, Düsseldorf Institute for Competition Economics (DICE).
    2. Matteo Crosignani & Miguel Faria-e-Castro & Luís Fonseca, 2016. "The (unintended?) consequences of the largest liquidity injection ever," ESRB Working Paper Series 31, European Systemic Risk Board.
    3. Stephan Luck & Paul Schempp, 2014. "Sovereign Defaults, Bank Runs, and Contagion," Discussion Paper Series of the Max Planck Institute for Research on Collective Goods 2014_15, Max Planck Institute for Research on Collective Goods.
    4. Alessandro Beber & Daniela Fabbri & Marco Pagano & Saverio Simonelli, 2015. "Short-Selling Bans and Bank Stability," CSEF Working Papers 423, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy, revised 15 Dec 2017.
    5. Becker, Bo & Ivashina, Victoria, 2017. "Financial Repression in the European Sovereign Debt Crisis," CEPR Discussion Papers 12185, C.E.P.R. Discussion Papers.
    6. 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.
    7. Vergote, Olivier, 2016. "Credit risk spillover between financials and sovereigns in the euro area during 2007-2015," Working Paper Series 1898, European Central Bank.
    8. Luigi Bocola, 2016. "The Pass-Through of Sovereign Risk," Journal of Political Economy, University of Chicago Press, vol. 124(4), pages 879-926.
    9. Anil Ari, 2015. "Sovereign Risk and Bank Risk-Taking," Working Papers 202, Oesterreichische Nationalbank (Austrian Central Bank).
    10. Kok, Christoffer & Hałaj, Grzegorz & Hüser, Anne-Caroline & Perales, Cristian & van der Kraaij, Anton, 2017. "The systemic implications of bail-in: a multi-layered network approach," Working Paper Series 2010, European Central Bank.
    11. Markus K. Brunnermeier & Luis Garicano & Philip R. Lane & Marco Pagano & Ricardo Reis & Tano Santos & David Thesmar & Stijn Van Nieuwerburgh & Dimitri Vayanos, 2016. "The Sovereign-Bank Diabolic Loop and ESBies," American Economic Review, American Economic Association, vol. 106(5), pages 508-512, May.
    12. Matteo Crosignani, 2015. "Why Are Banks Not Recapitalized During Crises?," Working Papers 203, Oesterreichische Nationalbank (Austrian Central Bank).
    13. Kirschenmann, Karolin & Korte, Josef & Steffen, Sascha, 2017. "The zero risk fallacy? Banks' sovereign exposure and sovereign risk spillovers," ZEW Discussion Papers 17-069, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
    14. Leonello, Agnese, 2017. "Government guarantees and the two-way feedback between banking and sovereign debt crises," Working Paper Series 2067, European Central Bank.
    15. Farhi, Emmanuel & Tirole, Jean, 2015. "Deadly Embrace: Sovereign and Financial Balance Sheets Doom Loops," CEPR Discussion Papers 11024, C.E.P.R. Discussion Papers.
    16. Gruber, Alexander & Kogler, Michael, 2016. "Banks and Sovereigns: A Model of Mutual Contagion," Economics Working Paper Series 1614, University of St. Gallen, School of Economics and Political Science.
    17. repec:eee:eecrev:v:100:y:2017:i:c:p:337-363 is not listed on IDEAS
    18. Jakob Korbinian Eberl, 2016. "The Collateral Framework of the Eurosystem and Its Fiscal Implications," ifo Beiträge zur Wirtschaftsforschung, ifo Institute - Leibniz Institute for Economic Research at the University of Munich, number 69.
    19. Fernando Martin & Aleksander Berentsen & David Andolfatto, 2016. "Financial Fragility in Monetary Economies," 2016 Meeting Papers 1626, Society for Economic Dynamics.
    20. Vlassopoulos, Thomas & C. Andreeva, Desislava, 2016. "Home bias in bank sovereign bond purchases and the bank-sovereign nexus," Working Paper Series 1977, European Central Bank.

    More about this item

    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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