Bailouts, Moral Hazard and Banks’ Home Bias for Sovereign Debt

Gaetano Gaballo and Ariel Zetlin-Jones

Working Papers from European Stability Mechanism

Abstract: This paper shows that an increase in banks’ holdings of domestic sovereign debt decreases the ability of domestic sovereigns to successfully enact bailouts. When sovereigns finance bailouts with newly issued debt and the price of sovereign debt is sensitive to unanticipated debt issues, then bailouts dilute the value of banks’ sovereign debt holdings rendering bailouts less effective. We explore this feedback mechanism in a model of financial intermediation in which banks are subject to managerial moral hazard and ex ante optimality requires lenders to commit to ex post inefficient bank liquidations. A benevolent sovereign may desire to enact bailouts to prevent such liquidations thereby neutralizing lenders’ commitment. In this context, home bias for sovereign debt may arise as a mechanism to deter bailouts and restore lenders’ commitment.

Keywords: Bailout; Sovereign debt; Home bias; Time inconsistency; Commitment; Macroprudential regulation (search for similar items in EconPapers)
JEL-codes: E0 E44 E6 E61 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2016-07-15
New Economics Papers: this item is included in nep-ban and nep-mac
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Citations: View citations in EconPapers (7)

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Related works:
Journal Article: Bailouts, moral hazard and banks׳ home bias for Sovereign debt (2016)
Working Paper: Bailouts, Moral Hazard and Banks' Home Bias for Sovereign Debt (2016)
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Persistent link: https://EconPapers.repec.org/RePEc:stm:wpaper:16

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