GOVERNMENT DEBT AND BANKING FRAGILITY: THE SPREADING OF STRATEGIC UNCERTAINTY

Russell Cooper, Kalin Nikolov

Research output: Contribution to journalArticlepeer-review

13 Scopus citations

Abstract

This article studies the interaction of government debt and financial markets. This interaction, termed a “diabolic loop,” is driven by government choice to bail out banks and the resulting incentives for banks to hold government debt instead of self-insure through equity buffers. We highlight the role of bank equity issuance in determining whether the “diabolic loop” is a Nash equilibrium of the interaction between banks and the government. When equity is issued, no diabolic loop exists. In equilibrium, banks' rational expectations of a bailout ensure that no equity is issued and the sovereign-bank loop is operative.

Original languageEnglish (US)
Pages (from-to)1905-1925
Number of pages21
JournalInternational Economic Review
Volume59
Issue number4
DOIs
StatePublished - Nov 2018

All Science Journal Classification (ASJC) codes

  • Economics and Econometrics

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