The bright side of the doom loop: Banks' sovereign exposure and default incentives

The feedback loop between sovereign and financial sector insolvency has been identified as a key driver of the European debt crisis and has motivated an array of policy proposals. We revisit this "doom loop" focusing on governments' incentives to default. To this end, we present a simple 3-period model with strategic sovereign default, where debt is held by domestic banks and foreign investors. The government maximizes domestic welfare, and thus the temptation to default increases with externally-held debt. Importantly, the costs of default arise endogenously from the damage that default causes to domestic banks' balance sheets. Domestically-held debt thus serves as a commitment device for the government. We show that two prominent policy prescriptions - lower exposure of banks to domestic sovereign debt or a commitment not to bailout banks - can backfire, since default incentives depend not only on the quantity of debt, but also on who holds it. Conversely, allowing banks to buy additional sovereign debt in times of sovereign distress can avert the doom loop. In an extension we show that in the context of a monetary union (such as the euro area) similar unintended negative consequences may arise from the pooling of debt (such as European safe bond aka. ESBies). A backstop by the central bank (such as the ECB's Transmission Protection Instrument) can successfully disable the loop if precisely calibrated.