Events at CERGE-EI

Dr. Kalin Nikolov

ECB, Frankfurt am Main, Germany

Authors: Russell Cooper and Kalin Nikolov

Abstract: This paper studies the interaction of government debt and banking markets. Both markets are known to be fragile: excessively responsive to fundamentals and prone to strategic uncertainty. Our analysis highlights the spillover from fragility in debt markets on banks and, through government bailout of troubled banks, spillovers from banks to the debt market. This interaction, termed a 'diabolic loop', is driven by government willingness to bail out banks and the resulting incentives for banks not to self-insure through equity buyers. We provide conditions such that the 'diabolic loop' is a Nash Equilibrium of the interaction between banks and the government.

Full Text:  “Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty”