Optimal bailouts and the doom loop with a financial network.

Citation metadata

Date: May 2022
Publisher: Elsevier B.V.
Document Type: Report; Brief article
Length: 368 words

Document controls

Main content

Abstract :

Keywords Financial networks; Home bias; Sovereign debt; Bailouts; Doom loop Highlights * The paper studies how the interaction of doom loop and financial networks affects bailout choices. * Our model illustrates how the doom loop exacerbates the "too interconnected to fail" problem. * Our results provide a rationale for capital requirements that increase with sovereign debt exposure. * Rescuing banks with high domestic sovereign exposure is optimal if these banks are very central. 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 sovereign debt ownership 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. Author Affiliation: (a) Columbia University, 3022 Broadway, New York, NY 10027, United States (b) European University Institute, Via delle Fontanelle 18, San Domenico di Fiesole 50014, Italy * Corresponding author. Article History: Received 10 July 2021; Revised 5 March 2022; Accepted 7 March 2022 (footnote)[white star] We would like to thank the editor Fred Malherbe, three anonymous referees, Árpád Ábrahám, Viral Acharya, Thorsten Beck, Edouard Challe, Nicola Fuchs-Schündeln, Paul Glasserman, Piero Gottardi, Philipp Grübener, Philipp Kircher, Anton Korinek, Steve Kou, Ramon Marimon, Lukas Nord, Giorgia Piacentino, Vincenzo Quadrini, Rafael Repullo, Stefan Schmitz, our discussants Flora Lutz, Anjan Thakor, and Dimitri Vayanos, conference participants at the 5thAnnual Conference on Network Science in Economics, the EEA Virtual Congress 2020, the 7th Sovereign Bond Markets Conference 2020 (Bank of England), the 9th Workshop on Banks and Financial Markets (Vienna), the 2021 SED Annual Meeting, the 20th Annual FDIC/JFSR Bank Research Conference, and seminar participants at NYU and EUI for their helpful comments. The research of Agostino Capponi has been supported by a NSF-CMMI: 1752326 CAREER grant. Byline: Agostino Capponi [ac3827@columbia.edu] (*,a), Felix Corell (b), Joseph E. Stiglitz (a)

Source Citation

Source Citation   

Gale Document Number: GALE|A703193414