Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty

66 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 13, 2018

Abstract

This paper 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 rather than 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.

Keywords: sovereign default, sovereign-banking loop

JEL Classification: G01, G28, E44

Suggested Citation

Cooper, Russell and Nikolov, Kalin, Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty (November 13, 2018). ECB Working Paper No. 2195. Available at SSRN: https://ssrn.com/abstract=3284429

Russell Cooper

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 (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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