The “doom loop” and default incentives

The “doom loop” or “sovereign-bank nexus” has been a key factor in the European debt crisis, driven by feedback between fiscal sustainability risks and financial stability. This Research Bulletin revisits the doom loop, examining strategic default incentives and the unintended effects of policy interventions. While limiting banks’ exposure to sovereign debt can break the doom loop, it may increase default risks by weakening governments’ repayment incentives. Similarly, measures like the ECB’s Transmission Protection Instrument (TPI) or European Safe Bonds (ESBies) can mitigate the doom loop but might introduce new vulnerabilities, requiring precise calibration. Counterintuitively, allowing banks to increase sovereign bond holdings during crises may stabilise markets by reducing default incentives. These findings underscore the complex trade-offs and the need for nuanced policy design at both national and monetary union levels.