The Sovereign-Bank Diabolic Loop and Esbies
14 Pages Posted: 25 Jan 2016 Last revised: 14 Jun 2016
Date Written: May 12, 2016
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
JEL Classification: G18, G21, G28, H63
Suggested Citation: Suggested Citation