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Bailouts, Moral Hazard, and Banks’ Home Bias for Sovereign Debt

Author

Listed:
  • Ariel Zetlin-Jones

    (Carnegie Mellon University)

  • Gaetano Gaballo

    (Banque de France)

Abstract

We show that an increase in banks’ holdings of domestic sovereign debt decreases the ability of domestic Sovereigns to successfully enact bailouts. When Sovereigns finance bailouts with newly issued debt and the price of sovereign debt is sensitive to unanticipated debt issues, then bailouts dilute the value of banks’ sovereign debt holdings rendering bailouts less effective. We explore this feedback mechanism in a model of financial intermediation in which banks are subject to managerial moral hazard and ex ante optimality requires lenders to commit to ex post inefficient bank liquidations. A benevolent Sovereign may desire to enact bailouts to prevent such liquidations thereby neutralizing lenders’ commitment. In this context, home bias for sovereign debt may arise as a mechanism to deter bailouts and restore lenders’ commitment.

Suggested Citation

  • Ariel Zetlin-Jones & Gaetano Gaballo, 2016. "Bailouts, Moral Hazard, and Banks’ Home Bias for Sovereign Debt," 2016 Meeting Papers 876, Society for Economic Dynamics.
  • Handle: RePEc:red:sed016:876
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    File URL: https://economicdynamics.org/meetpapers/2016/paper_876.pdf
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    Cited by:

    1. Eichler, Stefan & Rövekamp, Ingmar, 2017. "Eurozone exit risk," CEPIE Working Papers 07/17, Technische Universität Dresden, Center of Public and International Economics (CEPIE).
    2. repec:oup:ecpoli:v:32:y:2017:i:90:p:175-219. is not listed on IDEAS
    3. Markus K. Brunnermeier & Sam Langfield & Marco Pagano & Ricardo Reis & Stijn Van Nieuwerburgh & Dimitri Vayanos, 2017. "ESBies: safety in the tranches," Economic Policy, CEPR;CES;MSH, vol. 32(90), pages 175-219.
    4. repec:oup:revfin:v:21:y:2017:i:1:p:363-385. is not listed on IDEAS
    5. Francisco Roch & Harald Uhlig, 2016. "The Dynamics of Sovereign Debt Crises and Bailouts," IMF Working Papers 16/136, International Monetary Fund.
    6. Anne-Laure Delatte & Julien Fouquau & Richard Portes, 2017. "Regime-Dependent Sovereign Risk Pricing During the Euro Crisis," Review of Finance, European Finance Association, vol. 21(1), pages 363-385.

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