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Working Paper

The 2012 Eurozone Crisis and the ECB's OMT Program: A Debt-Overhang Banking and Sovereign Crisis Interpretation

This paper develops a model to interpret the 2012 eurozone crisis and the ECB’s policy response. In the model, bank lending is distorted by debt overhang, banks hold sovereign bonds, and the government guarantees the bailout of bank creditors. A self-fulfilling pessimistic view of the economy can trigger a banking and sovereign crisis: with pessimistic economic expectations, the value of sovereign bonds declines, the bank risk of default rises, and the debt overhang distortion worsens; this leads to a contraction in bank lending and to a decline in economic activity, which confirms the initial pessimistic expectations. A commitment by the central bank to purchase the sovereign bonds at pre-crisis market spreads manages to eliminate the crisis equilibrium.

Working Papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded official Federal Reserve Bank of Cleveland publications. The views expressed in this paper are those of the authors and do not represent the views of the Federal Reserve Bank of Cleveland or the Federal Reserve System.


Suggested Citation

Occhino, Filippo. 2015. “The 2012 Eurozone Crisis and the ECB's OMT Program: A Debt-Overhang Banking and Sovereign Crisis Interpretation.” Federal Reserve Bank of Cleveland, Working Paper No. 15-09. https://doi.org/10.26509/frbc-wp-201509