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.