DP11024 Deadly Embrace: Sovereign and Financial Balance Sheets Doom Loops

Author(s): Emmanuel Farhi, Jean Tirole
Publication Date: December 2015
Keyword(s): bailouts, feedback loop, shared supervision, sovereign and corporate spreads, sovereign default
JEL(s): F34, F36, F65, G28, H63
Programme Areas: Financial Economics, International Macroeconomics and Finance, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11024

The recent unravelling of the Eurozone?s financial integration raised concerns about feedback loops between sovereign and banking insolvency, and provided an impetus for the European banking union. This paper provides a ?double-decker bailout? theory of the feedback loop that allows for both domestic bailouts of the banking system by the domestic government and sovereign debt forgiveness by international creditors or solidarity by other countries. Our theory has important implications for the re-nationalization of sovereign debt, macroprudential regulation, and the rationale for banking unions.