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

Luis Rojas () and Dominik Thaler

No 1143, Working Papers from Barcelona Graduate School of Economics

Abstract: We revisit the doom-loop debate emphasizing the commitment device that the exposure of the financial sector to sovereign debt provides to the sovereign. If this mechanism is strong then lower exposure or a commitment not to bailout banks, two policy prescriptions that have emerged in this literature, can backfire. We present a simple 3-period model with strategic sovereign default where debt is held by local banks or foreign investors and show that: i) Reducing exposure reduces commitment and hence increases the probability of default, without avoiding the “doom loop”. Furthermore, that allowing banks to buy additional sovereign debt in times of sovereign distress can rule out the doom loop. ii) A no bailout commitment is not sufficient to rule out self-fulfilling expectations.

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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