GOVERNMENT DEBT AND BANKING FRAGILITY: THE SPREADING OF STRATEGIC UNCERTAINTY

• Published date: 01 November 2018
• DOI: http://doi.org/10.1111/iere.12323
• Date: 01 November 2018

INTERNATIONAL ECONOMIC REVIEW

Vol. 59, No. 4, November 2018 DOI: 10.1111/iere.12323

GOVERNMENT DEBT AND BANKING FRAGILITY: THE SPREADING

OF STRATEGIC UNCERTAINTY∗

BYRUSSELL COOPER AND KALIN NIKOLOV1

Pennsylvania State University, U.S.A.; European Central Bank, Germany

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.

1. INTRODUCTION

The following quote is from a 2012 speech by IMF Director Christine Lagarde:

We must also break the vicious cycle of banks hurting sovereigns and sovereigns hurting banks. This

works both ways. Making banks stronger, including by restoring adequate capital levels, stops banks

from hurting sovereigns through higher debt or contingent liabilities. And restoring confidence in

sovereign debt helps banks, which are important holders of such debt and typically benefit from explicit

or implicit guarantees from sovereigns.2

This statement by Christine Lagarde highlights a natural feedback, often termed a “diabolic

loop” between a government’s incentive to bail out banks and its incentive to default on its own

debt.3There is ample evidence of these interactions.

Following the Greek sovereign debt write-down in 2011, the four largest Greek banks made

losses of more than 28 billion euros (or 13% of GDP).4This was enough to wipe out almost all

of their combined equity capital. Greek banks that were otherwise solvent were made insolvent

by the default of their sovereign whose debt they were holding.

In 2010, the Irish government ran an unprecedented peace-time deficit, reaching 32% of GDP

as it bailed out its banking system. Under the weight of nationalized banks’ losses, Ireland was

forced to seek financial support from the IMF and the EU in November 2010. In this case, a

government that had previously had one of the lowest levels of debt to GDP in Europe suffered

a withdrawal of funding as markets became concerned about the contingent liabilities involved

in bailing out its large, insolvent banking system.

∗Manuscript received July 2016; revised September 2017.

1We are grateful to seminar participants at the Federal Reserve Bank of Kansas City, the Cornell-PSU Fall 2013

meeting, McGill University, the International Macroeconomics Conference at the Federal Reserve Bank of Atlanta,

the University of Pittsburgh, the Riksbank, and the Guanghua School of Management at Peking University for helpful

comments and questions. We much appreciate the suggestions and guidance of the editor, Hal Cole, and referees in de-

velopment of this article. Please address correspondence to: Kalin Nikolov, European Central Bank, Sonnemannstrasse

20, 60314 Frankfurt am Main, Germany. Phone: +49 69 1344 8482. E-mail: Kalin.Nikolov@ecb.int.

2This entire speech by Christine Lagarde, Managing Director, IMF, is available at https://www.imf.org/external/

np/speeches/2012/012312.htm

3The term “diabolic loop” was evidently coined by Markus Brunnermeier in a presentation on the Euro Crisis at the

July 2012 NBER Summer Institute.

4National Bank of Greece, Alpha Bank, Pireus, and Eurobank.

1905

C

(2018) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social

and Economic Research Association

1906 COOPER AND NIKOLOV

Throughout the rest of southern Europe (most notably Italy and Spain), this “diabolic loop”

has not led to outright sovereign default but nevertheless contributed to strains in sovereign

and bank debt markets due to beliefs that government default was increasingly likely. Although

outright default is infrequent, the interaction between beliefs (confidence) about default and

the functioning of the intermediation process, as in these countries, is part of the “diabolic

loop.” This is consistent with the emphasis on “confidence” and thus beliefs about default in

the quote of Christine Lagarde.

The goal of this article is to identify the conditions for the existence of a “diabolic loop.”

The analysis identifies three key components. First, the valuation of government debt reflects

uncertainty regarding the prospect of default. Second, banks hold government debt, and their

operations are affected by fluctuations in the price of this asset. Third, the government has an

incentive to bail out banks that get into solvency problems. We discuss these in turn.

The analysis ties the fragility in asset markets to beliefs of agents about government default.

This is, in turn, connected to the willingness of the government to bail out banks, as in Ireland.5

In this case, pessimism about government default hurts banks’ balance sheets and thus induces

the government to bail out banks to prevent them from collapsing. The government’s choice,

however, increases the likelihood of a sovereign default. This is the “diabolic loop” in its purest

form—the government’s bailout decision saves the banks from the immediate consequences of

pessimism but also validates the initial pessimism itself.

This mechanism relies on the fact that banks hold the debt of their own government and do

not issue sufficient equity to protect their solvency from declines in the price of government

debt. This is indeed the case in the data. Banks tend to hold (their own) government debt while

treating it as a riskless asset when calculating how much bank capital they should maintain to

protect depositors against loss.

The model has implications that are fully consistent with this feature of the data. Banks

have no incentive to issue equity because they anticipate a government bailout if they get into

trouble. In fact, they increase their holdings of risky government bonds because they expect

to be compensated if losses occur. We identify plausible conditions, related to the costs of

sovereign default and a breakdown of the banking system, that lead governments to bail out

banks in the event of insolvency thus validating the initial expectations. Consequently, in an

equilibrium with government bailout, banks are incentivized to buy a lot of government bonds

without issuing equity.

Both of these features of the equilibrium are the result of optimizing choices by banks and

governments. The “diabolic loop” exists as a subgame perfect Nash equilibrium.

Importantly, the analysis, consistent with the episodes described above, makes clear that

bailouts of domestic banks by national governments contribute to, instead of offset, the insta-

bility of debt markets. This is made explicit in our model as sovereign debt fragility arises due

to a strategic complementarity between the buyers of government bonds, operating through

government default, as in Calvo (1988). Since the government’s ability to repay debt depends

inversely on the real interest rate it has to pay, this opens up the possibility of self-fulfilling

pessimistic equilibria in which the high interest rate needed to compensate bond holders for

high expected default risk weakens the government’s solvency and validates the pessimistic

default expectations.

Given the instability of debt markets, how are households insured? The insurance may arise

through the banking system, where the risk is borne by risk-neutral bank equity investors who

absorb any losses on bank government bond holdings. Or, the insurance may arise through a

government bailout of the banks, financed by government borrowing. We show that the two

modes of providing insurance deliver the same utility to risk-averse households but at very

different social cost. Although insuring through equity is costless and avoids debt fragility,

bailouts are the reason for debt fragility and bring deadweight default losses to the extent that

they lead to a positive probability of government insolvency.

5The analysis discusses other mechanisms such as the financing of fixed government expenditures and debt rollover.