Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty
NBER Working Paper No. 19278
This paper studies the interaction of government debt and banking markets. Both markets are known to be fragile: excessively responsive to fundamentals and prone to strategic uncertainty. Our analysis highlights the spillover from fragility in debt markets on banks and, through government bailout of troubled banks, spillovers from banks to the debt market. This interaction, termed a 'diabolic loop', is driven by government willingness to bail out banks and the resulting incentives for banks not to self-insure through equity buffers. We provide conditions such that the 'diabolic loop' is a Nash Equilibrium of the interaction between banks and the government.
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This paper was revised on February 19, 2014
Document Object Identifier (DOI): 10.3386/w19278
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