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The sovereign-bank diabolic loop and ESBies

Brunnermeier, Markus K. and Garicano, Luis and Lane, Philip R. and Pagano, Marco and Reis, Ricardo and Santos, Tano and Thesmar, David and Nieuwerburgh, Stijn Van and Vayanos, Dimitri (2016) The sovereign-bank diabolic loop and ESBies. CEP Discussion Paper, 1414. Centre for Economic Performance, London School of Economics and Political Science, London, UK.

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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.

Item Type: Monograph (Discussion Paper)
Official URL: http://cep.lse.ac.uk/
Additional Information: © 2016 The Authors
Divisions: Economics
Finance
Centre for Economic Performance
Subjects: H Social Sciences > HG Finance
JEL classification: G - Financial Economics > G1 - General Financial Markets > G18 - Government Policy and Regulation
G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
G - Financial Economics > G2 - Financial Institutions and Services > G28 - Government Policy and Regulation
H - Public Economics > H6 - National Budget, Deficit, and Debt > H63 - Debt; Debt Management
Sets: Departments > Economics
Departments > Finance
Research centres and groups > Centre for Economic Performance (CEP)
Series: Working Papers > CEP Discussion Papers
Date Deposited: 09 May 2016 15:43
Last Modified: 14 Feb 2018 12:28
Funders: Economic and Social Research Council, Economic and Social Research Council
URI: http://eprints.lse.ac.uk/id/eprint/66429

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