Optimal bailouts and the doom loop with a financial network

Agostino Capponi; Felix Corell; Joseph E. Stiglitz

doi:10.1016/j.jmoneco.2022.03.004

Optimal bailouts and the doom loop with a financial network

Agostino Capponi^*
, Felix Corell
, Joseph E. Stiglitz

^*Corresponding author for this work

Research output: Contribution to Journal › Article › Academic › peer-review

Abstract

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 sovereign debt ownership 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.

Original language	English
Pages (from-to)	35-50
Number of pages	16
Journal	Journal of Monetary Economics
Volume	128
DOIs	https://doi.org/10.1016/j.jmoneco.2022.03.004
Publication status	Published - May 2022
Externally published	Yes

Bibliographical note

Funding Information:
☆ We would like to thank the editor Fred Malherbe, 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 research of Agostino Capponi has been supported by a NSF-CMMI: 1752326 CAREER grant.

Funding Information:
We would like to thank the editor Fred Malherbe, 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 5 th Annual Conference on Network Science in Economics, the EEA Virtual Congress 2020, the 7 th Sovereign Bond Markets Conference 2020 (Bank of England), the 9 th Workshop on Banks and Financial Markets (Vienna), the 2021 SED Annual Meeting, the 20 th Annual FDIC/JFSR Bank Research Conference, and seminar participants at NYU and EUI for their helpful comments. The research of Agostino Capponi has been supported by a NSF-CMMI: 1752326 CAREER grant.

Publisher Copyright:
© 2022 Elsevier B.V.

Funding

☆ We would like to thank the editor Fred Malherbe, 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 research of Agostino Capponi has been supported by a NSF-CMMI: 1752326 CAREER grant. We would like to thank the editor Fred Malherbe, 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 5 th Annual Conference on Network Science in Economics, the EEA Virtual Congress 2020, the 7 th Sovereign Bond Markets Conference 2020 (Bank of England), the 9 th Workshop on Banks and Financial Markets (Vienna), the 2021 SED Annual Meeting, the 20 th Annual FDIC/JFSR Bank Research Conference, and seminar participants at NYU and EUI for their helpful comments. The research of Agostino Capponi has been supported by a NSF-CMMI: 1752326 CAREER grant.

Keywords

Bailouts
Doom loop
Financial networks
Home bias
Sovereign debt

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10.1016/j.jmoneco.2022.03.004

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Cite this

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title = "Optimal bailouts and the doom loop with a financial network",

abstract = "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 sovereign debt ownership 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.",

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doi = "10.1016/j.jmoneco.2022.03.004",

language = "English",

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AU - Corell, Felix

AU - Stiglitz, Joseph E.

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N2 - 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 sovereign debt ownership 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.

AB - 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 sovereign debt ownership 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.

KW - Bailouts

KW - Doom loop

KW - Financial networks

KW - Home bias

KW - Sovereign debt

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SN - 0304-3932

VL - 128

SP - 35

EP - 50

JO - Journal of Monetary Economics

JF - Journal of Monetary Economics

ER -

Optimal bailouts and the doom loop with a financial network

Abstract

Bibliographical note

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Keywords

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