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The Sovereign-Bank Diabolic Loop and ESBies

Author(s): Brunnermeier, Markus K.; Garicano, Luis; Lane, Philip R.; Pagano, Marco; Reis, Ricardo; et al

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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.
Publication Date: May-2016
Citation: Brunnermeier, Markus K., Garicano, Luis, Lane, Philip R., Pagano, Marco, Reis, Ricardo, Santos, Tano, Thesmar, David, Van Nieuwerburgh, Stijn, Vayanos, Dimitri. (2016). The Sovereign-Bank Diabolic Loop and ESBies. American Economic Review, 106 (5), 508 - 512. doi:10.1257/aer.p20161107
DOI: doi:10.1257/aer.p20161107
ISSN: 0002-8282
Pages: 508 - 512
Type of Material: Journal Article
Journal/Proceeding Title: American Economic Review
Version: Final published version. Article is made available in OAR by the publisher's permission or policy.

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