Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty
66 Pages Posted: 14 Nov 2018
Date Written: November 13, 2018
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: Suggested Citation