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)
Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
Number of pages: 16Posted: 15 Feb 2016Last Revised: 04 Feb 2023
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The Sovereign-Bank Diabolic Loop and ESBies
CEPR Discussion Paper No. DP11317
Number of pages: 17Posted: 13 Jun 2016
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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
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
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