Optimal Bailouts and the Doom Loop with a Financial Network
Banks usually hold large amounts of domestic debt which makes them vulnerable to their own sovereign's default risk. At the same time, governments often resort to costly bailouts when their banking sector is in trouble. We investigate how the network structure and the distribution of ownership of sovereign debt within the banking sector jointly affect the optimal bailout policy under this “doom loop”. We argue that rescuing banks with high domestic sovereign exposure is optimal if these banks are sufficiently central, even though that requires larger bailout expenditures than rescuing otherwise identical low-exposure banks. Our model illustrates how the “doom loop” exacerbates the “too interconnected to fail” problem.
We would like to thank the editor, three anonymous referees, Árpád Ábrahám, Viral Acharya, Thorsten Beck, Edouard Challe, Nicola Fuchs-Schündeln, Paul Glasserman, Piero Gottardi, Philipp Grübener, Philipp Kircher, Anton Korinek, Steve Kou, Ramon Marimon, Lukas Nord, Giorgia Piacentino, Vincenzo Quadrini, Rafael Repullo, Stefan Schmitz, our discussants Flora Lutz, Anjan Thakor, and Dimitri Vayanos, conference participants at the 5th Annual Conference on Network Science in Economics, the EEA Virtual Congress 2020, the 7th Sovereign Bond Markets Conference 2020 (Bank of England), the 9th Workshop on Banks and Financial Markets (Vienna), the 2021 SED Annual Meeting, the 20th Annual FDIC/JFSR Bank Research Conference, 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.
Agostino Capponi & Felix Corell & Joseph E. Stiglitz, 2022. "Optimal Bailouts and the Doom Loop with a Financial Network," Journal of Monetary Economics, . citation courtesy of