Gaballo, Gaetano, Zetlin-Jones, Ariel, (2016), “Bailouts, Moral Hazard and Banks’ Home Bias for Sovereign Debt“, ESM Working Paper Series, July
We show that an increase in banks’ holdings of domestic sovereign debt decreases the ability of domestic sovereigns to successfully enact bailouts. When sovereigns finance bailouts with newly issued debt and the price of sovereign debt is sensitive to unanticipated debt issues, then bailouts dilute the value of banks’ sovereign debt holdings rendering bailouts less effective. We explore this feedback mechanism in a model of financial intermediation in which banks are subject to managerial moral hazard and ex ante optimality requires lenders to commit to ex post inefficient bank liquidations. A benevolent sovereign may desire to enact bailouts to prevent such liquidations thereby neutralizing lenders’ commitment. In this context, home bias for sovereign debt may arise as a mechanism to deter bailouts and restore lenders’ commitment.
Relevants Posts
- Ongena, Steven, Popov, Alexander, Van Horen, Neeltje, (2016), “The invisible hand of the government: “Moral suasion” during the European sovereign debt crisis”, European Central Bank, Working papers 1937, July
- Altavilla, Carlo, Pagano, Marco, Simonelli, Saverio, (2016), “Bank Exposures and Sovereign Stress Transmission”, Centre for Economic Policy Research, May