CSEF - University of Naples Federico II - Centre for Studies in Economics and Finance (CSEF); Einaudi Institute for Economics and Finance (EIEF); Research Institute of Industrial Economics (IFN); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)
Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
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.
Keywords: diabolic loop, sovereign debt crisis, government default, bank default, bailout, ESBies
Brunnermeier, Markus Konrad and Garicano, Luis and Garicano, Luis and Lane, Philip R. and Pagano, Marco and Reis, Ricardo A.M.R. and Santos, Tano and Thesmar, David and Van Nieuwerburgh, Stijn and Vayanos, Dimitri, The Sovereign-Bank Diabolic Loop and Esbies (May 12, 2016). American Economic Review, Vol. 6, No. 5, May 2016, HEC Paris Research Paper No. FIN-2016-1133, Columbia Business School Research Paper No. 16-12, Available at SSRN: https://ssrn.com/abstract=2721365 or http://dx.doi.org/10.2139/ssrn.2721365
European Economics: Macroeconomics & Monetary Economics eJournal
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