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

36 Pages Posted: 4 Aug 2017

See all articles by Gaetano Gaballo

Gaetano Gaballo

Banque de France

Ariel Zetlin-Jones

University of Minnesota - Twin Cities - Department of Economics; Federal Reserve Bank of Minneapolis

Date Written: July 2016

Abstract

This paper shows 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.

Keywords: Bailout, Sovereign debt, Home bias, Time inconsistency, Commitment, Macroprudential regulation

JEL Classification: E0, E44, E6, E61

Suggested Citation

Gaballo, Gaetano and Zetlin-Jones, Ariel, Bailouts, Moral Hazard and Banks’ Home Bias for Sovereign Debt (July 2016). European Stability Mechanism Working Paper No. 16. Available at SSRN: https://ssrn.com/abstract=3013107 or http://dx.doi.org/10.2139/ssrn.3013107

Gaetano Gaballo (Contact Author)

Banque de France ( email )

Paris
France

Ariel Zetlin-Jones

University of Minnesota - Twin Cities - Department of Economics ( email )

271 19th Avenue South
Minneapolis, MN 55455
United States

Federal Reserve Bank of Minneapolis ( email )

90 Hennepin Avenue
Minneapolis, MN 55480
United States

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