The Sovereign-Bank Diabolic Loop and ESBies
by Markus Brunnermeier and Marco Pagano, Harvard Law School Forum
From 2009 to 2012, the euro area was roiled by financial crisis. In Greece, Ireland, Italy, Portugal, and Spain, perceptions of euro area sovereigns’ default risk shot up; banks approached insolvency and struggled to obtain funding. The “diabolic loop” between the credit risk of sovereigns and that of banks was a hallmark of the crisis. In our paper, forthcoming in the American Economic Review: Papers and Proceedings, we propose a simple model of this sovereign-bank diabolic loop, and show that it can be avoided by restricting banks’ domestic sovereign exposures relative to their equity. Furthermore, we show that equity requirements can be reduced if banks only hold the senior tranche of an internationally diversified sovereign portfolio—known as ESBies (European Safe Bonds) in the euro-area context.
The euro-area crisis illustrates that the sovereign-bank diabolic loop really consists of...