Les Cahiers de Recherche - HEC Paris
The Sovereign-Bank Diabolic Loop and Esbies
(), Markus K Brunnermeier, Luis Garicano, Philip R Lane, Marco Pagano, Ricardo Reis, Tano Santos, Stijn Van Nieuwerburgh and 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: diabolic loop; sovereign debt crisis; government default; bank default; bailout; ESBies; (follow links to similar papers)
JEL-Codes: G18; G21; (follow links to similar papers)
14 pages, May 12, 2016
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