“Doom Loop” Crises: The Sovereign-Banking Nexus and Implications for Country Risk Management

A “doom loop” is a particularly disruptive form of economic crisis, that occurs when a negative feedback loop forms between a country’s deteriorating banking sector and the credit risk of sovereign debt. This type of crisis arises because the domestic banking sector is the largest holder of sovereign debt in many countries. If the sovereign defaults or the debt loses value, the banking sector may become undercapitalized or insolvent. Alternatively, the transmission mechanism can be reversed: a banking crisis could require a bailout or other large fiscal outlay at a time of declining output, and a country’s debt load can become unsustainable.  

The aim of this project was to support the efforts of the Sovereign and Economic Risk Group at Goldman Sachs in developing a better understanding of the dynamics of these negative feedback loops and the key attributes of the sovereign-banking nexus. Based on an extensive literature review, the Capstone team compiled a database of past doom loop events since the 1970s to derive important historical context for the evaluation of current doom loop risks. The team then constructed a scorecard for over 100 developed and emerging markets, building on the structure used by many ratings agencies. This scorecard incorporates variables they identified through a rigorous quantitative analysis of past events to better capture the specific risk of a doom loop scenario occurring in a given country beyond what traditional sovereign ratings would suggest. This scorecard enables Goldman Sachs to incorporate doom loop risk into their broader country risk management practices.