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

Dominik Thaler and Luis Rojas

No 1143, Working Papers from Barcelona School of Economics

Abstract: The feedback loop between sovereign and financial sector insolvency 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 governments' 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 with externally-held debt. Importantly, the costs of default arise endogenously from the damage that default causes to domestic banks' balance sheets. Internally-held debt thus serves as a commitment device for the government. We show that two prominent policy prescriptions – lower exposure of banks to domestic sovereign debt or a commitment not to bailout banks – can backfire, since default incentives depend not only on the quantity of debt, but also on who holds it. Conversely, allowing banks to buy additional sovereign debt in times of sovereign distress can avert the doom loop.

Keywords: sovereign default; bailout; doom loop; self-fulfilling crises (search for similar items in EconPapers)
JEL-codes: E44 E6 F34 (search for similar items in EconPapers)
Date: 2020-01
New Economics Papers: this item is included in nep-ban, nep-dge and nep-mac
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Persistent link: https://EconPapers.repec.org/RePEc:bge:wpaper:1143

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