The Sovereign-Bank Diabolic Loop and ESBies

Markus Brunnermeier, Luis Garicano, Philip Lane, Marco Pagano, Ricardo Reis, Tano Santos, David Thesmar, Stijn Van Nieuwerburgh and Dimitri Vayanos
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Tano Santos: Columbia University

CSEF Working Papers from Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy

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: diabolic loop; sovereign debt crisis; government default; bank default; bailout; ESBies (search for similar items in EconPapers)
JEL-codes: G18 G21 G28 H63 (search for similar items in EconPapers)
Date: 2016-01-25, Revised 2016-06-18
New Economics Papers: this item is included in nep-eec
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Citations: View citations in EconPapers (20)

Forthcoming in American Economic Review. Papers and Proceedings 2016

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Persistent link: https://EconPapers.repec.org/RePEc:sef:csefwp:427

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