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Discussion Paper Details

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Title: The Sovereign-Bank Diabolic Loop and ESBies

Author(s): Markus K Brunnermeier, Luis Garicano, Philip R. Lane, Marco Pagano, Ricardo Reis, Tano Santos, David Thesmar, Stijn van Nieuwerburgh and Dimitri Vayanos

Publication Date: June 2016

Keyword(s): bailout, bank default, diabolic loop, ESBies, government default and sovereign debt crisis

Programme Area(s): Financial Economics, International Macroeconomics and Finance, Monetary Economics and Fluctuations and Public Economics

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.

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Bibliographic Reference

Brunnermeier, M, Garicano, L, Lane, P, Pagano, M, Reis, R, Santos, T, Thesmar, D, van Nieuwerburgh, S and Vayanos, D. 2016. 'The Sovereign-Bank Diabolic Loop and ESBies'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=11317