The Bright Side of the Doom Loop: Banks Exposure and Default Incentives

Abstract

We revisit the doom-loop debate emphasizing the commitment device that the exposure of the financial sector to sovereign debt provides to the sovereign. If this mechanism is strong then lower exposure or a commitment not to bailout banks, two policy prescriptions that have emerged in this literature, can backfire. We present a simple 3-period model with strategic sovereign default where debt is held by local banks or foreign investors and show that: i) Reducing exposure reduces commitment and hence increases the probability of default, without avoiding the “doom loop”. Furthermore, that allowing banks to buy additional sovereign debt in times of sovereign distress can rule out the doom loop. ii) A no bailout commitment is not sufficient to rule out self-fulfilling expectations.