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The Bright Side of the Doom Loop: Banks Exposure and Default Incentives

Author

Listed:
  • Luis Rojas
  • Dominik Thaler
Abstract
The feedback loop between sovereign and financial sector solvency has been identified as a key driver of the European debt crisis and has motivated an array of policy proposals. We revisit this “doom-loop” focusing on the government’s incentives to default. To this end we present a simple 3-period model with strategic sovereign default where debt is held by domestic banks and foreign investors. The government maximizes domestic welfare, and thus the temptation to default increases in foreign debt. Importantly, the costs of default arise endogenously from the damage default causes to domestic banks’ balance sheets. Domestically held debt thus serves a commitment device for the government. We show that two policy prescriptions that have emerged in this literature – lower exposure of banks to domestic sovereign debt or a commitment not to bailout banks – can backfire, as default incentives depend not just on the quantity of debt but also on who holds the debt. By contrast, allowing banks to buy additional sovereign debt in times of sovereign distress can rule out the doom loop.

Suggested Citation

  • Luis Rojas & Dominik Thaler, 2020. "The Bright Side of the Doom Loop: Banks Exposure and Default Incentives," Working Papers 1143, Barcelona School of Economics.
    • Handle: RePEc:bge:wpaper:1143
    as

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    File URL: https://www.barcelonagse.eu/sites/default/files/working_paper_pdfs/1143.pdf
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    sovereign default; bailout; doom loop; self-fulfilling crises;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems

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