Government debt and banking fragility: the spreading of strategic uncertainty

Kalin Nikolov and Russell Cooper

No 2195, Working Paper Series from European Central Bank

Abstract: This paper studies the interaction of government debt and financial markets. This interaction, termed a ‘diabolic loop’, is driven by government choice to bail out banks and the resulting incentives for banks to hold government debt rather than self-insure through equity buffers. We highlight the role of bank equity issuance in determining whether the ‘diabolic loop’ is a Nash Equilibrium of the interaction between banks and the government. When equity is issued, no diabolic loop exists. In equilibrium, banks’ rational expectations of a bailout ensure that no equity is issued and the sovereign-bank loop is operative. JEL Classification: G01, G28, E44

Keywords: sovereign-banking loop; sovereign default (search for similar items in EconPapers)
Date: 2018-11
New Economics Papers: this item is included in nep-ban
Note: 288883
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Citations: View citations in EconPapers (50)

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Related works:
Journal Article: GOVERNMENT DEBT AND BANKING FRAGILITY: THE SPREADING OF STRATEGIC UNCERTAINTY (2018)
Working Paper: Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20182195

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