DP11317 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, Dimitri Vayanos
Publication Date:	June 2016
Keyword(s):	bailout, bank default, diabolic loop, ESBies, government default, sovereign debt crisis
JEL(s):	G18, G21, G28, H63
Programme Areas:	Public Economics, Financial Economics, International Macroeconomics and Finance, Monetary Economics and Fluctuations
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=11317

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.