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Optimal Bailouts and the Doom Loop with a Financial Network

Agostino Capponi, Felix C. Corell and Joseph Stiglitz

No 27074, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Banks usually hold large amounts of domestic public debt which makes them vulnerable to their own sovereign’s default risk. At the same time, governments often resort to costly public bailouts when their domestic banking sector is in trouble. We investigate how the interbank network structure and the distribution of sovereign debt holdings jointly affect the optimal bailout policy in the presence of this "doom loop". Rescuing banks with high domestic sovereign exposure is optimal if these banks are sufficiently central in the network, even though that requires larger bailout expenditures than rescuing low-exposure banks. Our findings imply that highly central banks can use exposure to their own government as a strategic tool to increase the likelihood of being bailed out. Our model thus illustrates how the "doom loop" exacerbates the "too interconnected to fail" problem in banking.

JEL-codes: G01 G21 G28 H63 H81 (search for similar items in EconPapers)
Date: 2020-05
New Economics Papers: this item is included in nep-ban, nep-cba and nep-net
Note: TWP
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