Optimal Bailouts and the Doom Loop with a Financial Network
Banks usually hold large amounts of domestic public debt which makes them vulnerable to their own sovereign’s default risk. At the same time, governments often resort to costly public bailouts when their domestic banking sector is in trouble. We investigate how the interbank network structure and the distribution of sovereign debt holdings jointly affect the optimal bailout policy in the presence of this "doom loop". Rescuing banks with high domestic sovereign exposure is optimal if these banks are sufficiently central in the network, even though that requires larger bailout expenditures than rescuing low-exposure banks. Our findings imply that highly central banks can use exposure to their own government as a strategic tool to increase the likelihood of being bailed out. Our model thus illustrates how the "doom loop" exacerbates the "too interconnected to fail" problem in banking.
We would like to thank Árpád Ábrahám, Nicola Fuchs-Schündeln, Paul Glasserman, Piero Gottardi, Philipp Grübener, Philipp Kircher, Anton Korinek, Steve Kou, Lukas Nord, Giorgia Piacentino, our discussant Flora Lutz, conference participants at the 5th Annual Conference on Network Science in Economics, the SIAM Conference on Financial Mathematics & Engineering 2019, the 9th Workshop on Banks and Financial Markets (Vienna) and seminar participants at NYU and EUI for their helpful comments. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.