The Sovereign-Bank Diabolic Loop and ESBies

17 Pages Posted: 13 Jun 2016

See all articles by Markus K. Brunnermeier

Markus K. Brunnermeier

Princeton University - Department of Economics

Luis Garicano

Centre for Economic Policy Research (CEPR); IE Business School

Philip R. Lane

Trinity College (Dublin) - Department of Economics; Centre for Economic Policy Research (CEPR); Central Bank of Ireland

Marco Pagano

CSEF - University of Naples Federico II - Centre for Studies in Economics and Finance (CSEF); Einaudi Institute for Economics and Finance (EIEF); Research Institute of Industrial Economics (IFN); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Ricardo Reis

London School of Economics & Political Science (LSE); National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Tano Santos

Columbia University

David Thesmar

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Stijn Van Nieuwerburgh

Columbia University Graduate School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); ABFER

Dimitri Vayanos

London School of Economics; Center for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: June 2016

Abstract

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: bailout, bank default, diabolic loop, ESBies, government default, sovereign debt crisis

JEL Classification: G18, G21, G28, H63

Suggested Citation

Brunnermeier, Markus Konrad and Garicano, Luis and Garicano, Luis and Lane, Philip R. and Pagano, Marco and Reis, Ricardo A.M.R. and Santos, Tano and Thesmar, David and Van Nieuwerburgh, Stijn and Vayanos, Dimitri, The Sovereign-Bank Diabolic Loop and ESBies (June 2016). CEPR Discussion Paper No. DP11317, Available at SSRN: https://ssrn.com/abstract=2795080

Markus Konrad Brunnermeier (Contact Author)

Princeton University - Department of Economics ( email )

Bendheim Center for Finance
Princeton, NJ
United States
609-258-4050 (Phone)
609-258-0771 (Fax)

HOME PAGE: http://www.princeton.edu/¡­markus

Luis Garicano

IE Business School ( email )

Calle María de Molina, 11
Madrid, 28006
Spain

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Philip R. Lane

Trinity College (Dublin) - Department of Economics ( email )

Trinity College
Dublin 2
Ireland
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+353 1 677 2503 (Fax)

Centre for Economic Policy Research (CEPR)

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United Kingdom

Central Bank of Ireland ( email )

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Ireland

Marco Pagano

CSEF - University of Naples Federico II - Centre for Studies in Economics and Finance (CSEF) ( email )

Via Cintia
Complesso Monte S. Angelo
Naples, Naples 80126
Italy

Einaudi Institute for Economics and Finance (EIEF)

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Rome, 00187
Italy

Research Institute of Industrial Economics (IFN)

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Sweden

Centre for Economic Policy Research (CEPR)

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United Kingdom

European Corporate Governance Institute (ECGI)

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Belgium

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Ricardo A.M.R. Reis

London School of Economics & Political Science (LSE) ( email )

Houghton Street
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National Bureau of Economic Research (NBER)

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Centre for Economic Policy Research (CEPR)

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Tano Santos

Columbia University ( email )

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New York, NY 10027
United States

David Thesmar

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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Cambridge, MA 02142
United States

National Bureau of Economic Research (NBER) ( email )

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Centre for Economic Policy Research (CEPR) ( email )

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Stijn Van Nieuwerburgh

Columbia University Graduate School of Business ( email )

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Dimitri Vayanos

London School of Economics ( email )

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Center for Economic Policy Research (CEPR)

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National Bureau of Economic Research (NBER)

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