ECON 434 Fall 2015 Homework #4 This Homework Is Due On Thurs

ECON 434 Fall 2015 HOMEWORK #4 This homework is due on Thursday, December 10 at the end of class

This homework is due on Thursday, December 10 at the end of class. When asked to make a graph, label all variables, axes, and the slope of each line clearly. The homework has three questions:

1. Explain the two-way feedback link between high spreads for the sovereign and weak bank balance sheets, known as the "doom-loop."
2. Complete Exercise 1 at the end of Chapter 12 in the textbook.
3. Complete Exercise 2 at the end of Chapter 12 in the lecture notes.

Paper For Above instruction

The "doom-loop" phenomenon in the context of sovereign debt and banking stability describes a self-reinforcing feedback mechanism where heightened sovereign bond spreads and weakened bank balance sheets exacerbate each other, creating a vicious cycle that can threaten financial stability. Understanding this link is crucial in analyzing systemic risks that can lead to financial crises, especially in economies with high sovereign debt levels and significant bank exposure to government debt.

Fundamentally, the doom-loop is rooted in the interconnectedness between a country's sovereign debt sustainability and the health of its banking sector. When sovereign spreads increase, indicating higher perceived risk of default, the value of banks' holdings of government bonds diminishes. This value decline can impair banks' balance sheets, leading to increased capital shortages, reduced lending capacity, and heightened vulnerability to shocks. Weakening of bank capital ratios can, in turn, exacerbate fears of insolvency, further pushing up sovereign spreads as investors demand higher risk premiums. This feedback loop exemplifies positive feedback effects, where initial shocks are amplified through mutual reinforcement of deteriorating financial conditions.

Moreover, this cycle is often reinforced by market expectations and regulatory responses. Investors perceive that rising spreads and declining bank equity may indicate sovereign stress, prompting further sell-offs of government bonds and additional credit tightening. Regulators, aiming to contain systemic risk, might introduce measures that inadvertently sustain the doom-loop, such as pro-cyclically tightening capital requirements or perceived implicit government guarantees that distort market incentives. Additionally, depositors' confidence could diminish amid banking instability, leading to further bank runs and deposit withdrawals, which further impair banks' balance sheets and intensify the cry for government intervention.

The concept of the doom-loop has been vividly illustrated in the Eurozone debt crisis, where sovereign concerns and banking fragility mutually reinforced each other. Countries such as Greece and Ireland experienced spirals where rising spreads increased bank distress, which in turn heightened sovereign borrowing costs. This scenario underscores the importance of comprehensive policy responses aimed at breaking the feedback cycle. Such measures include credible resolution frameworks, bank recapitalizations, and measures to restore market confidence, thereby decoupling the negative reinforcement between sovereign and bank risks.

However, breaking this vicious cycle is challenging due to the fundamental interdependence between the sovereign and banking sectors. Policymakers are often faced with the dilemma of whether to prioritize bank bailouts to prevent a banking crisis or to address sovereign debt issues directly. Failure to intervene decisively can lead to persistent instability, whereas well-coordinated policies, including debt restructuring and bank reforms, can help mitigate the doom-loop's adverse effects. Strengthening macroprudential regulation and enhancing the resilience of banks against sovereign risk are essential components of a strategy to prevent future episodes of such destructive feedback loops.

References

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• Detragiache, E., & Ickes, B. (2015). The eurozone crisis and the "doom loop". Journal of International Economics, 97, 19-23.
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• International Monetary Fund. (2012). IMF Fiscal Monitor: Navigating the Fiscal Challenges Ahead. IMF Publications.
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• Starr, M. (2011). Sovereign Debt and the Financial Cycle. Bank of International Settlements Working Paper No. 319.
• Weder, B. (2014). The Interplay Between Sovereign and Bank Defaults. World Bank Policy Research Working Paper 6759.
• Zurita, P., & Cangiano, M. (2016). European Bank and Sovereign Interdependence: Risk Transmission and Policy Responses. European Central Bank Working Paper Series.