Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty

21 Pages Posted: 14 Nov 2018

See all articles by Russell Cooper

Russell Cooper

Pennsylvania State University, College of the Liberal Arts - Department of Economic

Kalin Nikolov

European Central Bank (ECB)

Multiple version iconThere are 2 versions of this paper

Date Written: November 2018

Abstract

This article studies the interaction of government debt and financial markets. 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 instead of self‐insure through equity buffers. We highlight the role of bank equity issuance in determining whether the "diabolic loop" is a Nash equilibrium of the interaction between banks and the government. 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 is operative.

Suggested Citation

Cooper, Russell and Nikolov, Kalin, Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty (November 2018). International Economic Review, Vol. 59, Issue 4, pp. 1905-1925, 2018, Available at SSRN: https://ssrn.com/abstract=3284000 or http://dx.doi.org/10.1111/iere.12323

Russell Cooper (Contact Author)

Pennsylvania State University, College of the Liberal Arts - Department of Economic ( email )

524 Kern Graduate Building
University Park, PA 16802-3306
United States

Kalin Nikolov

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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