The bright side of the doom loop: Banks’ sovereign exposure and default incentives

Luis E. Rojas and Dominik Thaler

European Economic Review, 2024, vol. 170, issue C

Abstract: The feedback loop between sovereign and financial sector insolvency, termed the “doom loop”, was a key driver of the European debt crisis and motivated an array of policy proposals. This paper revisits the “doom loop” focusing on governments’ incentives to default. We introduce a 3-period model with strategic sovereign default, where debt is held by both domestic banks and foreign investors. The government maximizes domestic welfare; thus, the temptation to default increases with externally-held debt. Importantly, the cost of default arises endogenously from the damage that default causes to domestic banks’ balance sheets. Domestically-held debt thus serves as a commitment device for the government. We show that two prominent policy prescriptions – lower exposure of domestic 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 domestic banks to buy additional domestic sovereign debt during times of sovereign distress can avert the doom loop. In the context of a monetary union similar unintended negative consequences may arise from a backstop by the central bank (e.g., the ECB’s Transmission Protection Instrument) if imprecisely calibrated or the pooling of debt (e.g., European safe bond, also known as ESBies).

Keywords: Sovereign default; Bailout; Doom loop; Self-fulfilling crises; Transmission protection instrument; ESBies (search for similar items in EconPapers)
JEL-codes: E44 E6 F34 (search for similar items in EconPapers)
Date: 2024
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Citations: View citations in EconPapers (1)

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Related works:
Working Paper: The bright side of the doom loop: banks’ sovereign exposure and default incentives (2024)
Working Paper: The bright side of the doom loop: banks’ sovereign exposure and default incentives (2023)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:eecrev:v:170:y:2024:i:c:s0014292124002058

DOI: 10.1016/j.euroecorev.2024.104876

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