Working Paper: NBER ID: w27074
Authors: Agostino Capponi; Felix C. Corell; Joseph E. Stiglitz
Abstract: Banks usually hold large amounts of domestic debt which makes them vulnerable to their own sovereign's default risk. At the same time, governments often resort to costly bailouts when their banking sector is in trouble. We investigate how the network structure and the distribution of ownership of sovereign debt within the banking sector jointly affect the optimal bailout policy under this “doom loop”. We argue that rescuing banks with high domestic sovereign exposure is optimal if these banks are sufficiently central, even though that requires larger bailout expenditures than rescuing otherwise identical low-exposure banks. Our model illustrates how the “doom loop” exacerbates the “too interconnected to fail” problem.
Keywords: financial networks; home bias; sovereign debt; bailouts; doom loop
JEL Codes: G01; G21; G28; H63; H81
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| centrality of banks in the network (G21) | government bailout decisions (G28) |
| exposure to domestic sovereign debt (H63) | government bailout decisions (G28) |
| higher sovereign exposure (F34) | increased bailout costs (H81) |
| increased bailout costs (H81) | welfare losses (D69) |
| exposure to domestic sovereign debt (H63) | default probabilities (C25) |
| increased bailout expenditures (H81) | increased sovereign default probability (F34) |
| central banks leveraging sovereign debt positions (H63) | enhanced chances of being rescued (H84) |