Working Paper: NBER ID: w21993
Authors: Markus K. Brunnermeier; Luis Garicano; Philip Lane; Marco Pagano; Ricardo Reis; Tano Santos; David Thesmar; Stijn van Nieuwerburgh; Dimitri Vayanos
Abstract: We propose a simple model of the sovereign-bank diabolic loop, and establish four results. First, the diabolic loop can be avoided by restricting banks domestic sovereign exposures relative to their equity. Second, equity requirements can be lowered if banks only hold senior domestic sovereign debt. Third, such requirements shrink even further if banks only hold the senior tranche of an internationally diversified sovereign portfolio known as ESBies in the euro-area context. Finally, ESBies generate more safe assets than domestic debt tranching alone; and, insofar as the diabolic loop is defused, the junior tranche generated by the securitization is itself risk-free.
Keywords: Sovereign Debt; Banking; Financial Stability; ESBies
JEL Codes: E58; F34; G01; G15; G21; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Restricting banks' domestic sovereign exposures (F65) | avoiding the diabolic loop (C62) |
| Equity requirements can be lowered if banks only hold senior domestic sovereign debt (F34) | required equity levels (G12) |
| Diversification and seniority of bonds (G12) | equity requirements (G12) |
| ESBies generate more safe assets than domestic debt tranching alone (F34) | defusing the diabolic loop (C73) |
| Introduction of ESBies (F33) | making even the junior tranche risk-free (G19) |