Working Paper: CEPR ID: DP11024
Authors: Emmanuel Farhi; Jean Tirole
Abstract: The recent unravelling of the Eurozone?s financial integration raised concerns about feedback loops between sovereign and banking insolvency, and provided an impetus for the European banking union. This paper provides a ?double-decker bailout? theory of the feedback loop that allows for both domestic bailouts of the banking system by the domestic government and sovereign debt forgiveness by international creditors or solidarity by other countries. Our theory has important implications for the re-nationalization of sovereign debt, macroprudential regulation, and the rationale for banking unions.
Keywords: Bailouts; Feedback Loop; Shared Supervision; Sovereign and Corporate Spreads; Sovereign Default
JEL Codes: F34; F36; F65; G28; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Deterioration of sovereign creditworthiness (F34) | Bank solvency (G21) |
| Bank solvency (G21) | Public finances risk (H69) |
| Banking crisis (F65) | Sovereign debt issues (H63) |
| Banks facing distress (G21) | Government bailouts (H81) |
| Government bailouts (H81) | Sovereign fiscal capacity (E62) |
| Sovereign fiscal capacity (E62) | Potential defaults (Y20) |
| Government's decision to bail out banks (G28) | Anticipated economic fallout of bank insolvency (F65) |
| Anticipated economic fallout of bank insolvency (F65) | Sovereign's ability to issue debt (H63) |
| Supervisory leniency of domestic banks + Government bailouts (G28) | Risk-taking in banks (G21) |
| Risk-taking in banks (G21) | Exposure to sovereign risk (F34) |
| Exposure to sovereign risk (F34) | Higher borrowing costs (G21) |
| Perception of risk by investors (G11) | Pricing of sovereign debt (H63) |
| Pricing of sovereign debt (H63) | Government decisions regarding bailouts (G28) |