The Bright Side of the Doom Loop: Banks Exposure and Default Incentives

Abstract

The feedback loop between sovereign and financial sector solvency has been identified as a key driver of the European debt crisis and has motivated an array of policy proposals. We revisit this “doom-loop” focusing on the government’s incentives to default. To this end we present a simple 3-period model with strategic sovereign default where debt is held by domestic banks and foreign investors. The government maximizes domestic welfare, and thus the temptation to default increases in foreign debt. Importantly, the costs of default arise endogenously from the damage default causes to domestic banks’ balance sheets. Domestically held debt thus serves a commitment device for the government. We show that two policy prescriptions that have emerged in this literature – lower exposure of banks to domestic sovereign debt or a commitment not to bailout banks – can backfire, as default incentives depend not just on the quantity of debt but also on who holds the debt. By contrast, allowing banks to buy additional sovereign debt in times of sovereign distress can rule out the doom loop.