The "Greatest" Carry Trade Ever? Understanding Eurozone Bank Risks
AbstractThis paper argues that the European banking crisis can in part be explained by a “carry trade” behavior of banks. Factor loading estimates from multifactor models relating equity returns to GIPSI (Greece, Ireland, Portugal, Spain and Italy) and German government bond returns suggest that banks have been long peripheral sovereign bonds funded in short-term wholesale markets, a position that generated “carry” until the GIPSI bond returns deteriorated significantly inflicting significant losses on banks. We show that the positive GIPSI factor loadings reflect actual portfolio holdings of GIPSI bonds in the cross-section of banks; and, the negative German loading reflects funding risk (flight away from bank funding to German government bonds), a risk that is increasing in the US money market mutual fund exposures of European banks as well as various proxies for bank short-term debt. Large banks and banks with low Tier 1 ratios and high risk-weighted assets had particularly large exposures and even increased their exposures between the two European stress tests of March and December 2010 taking advantage of a widening of yield spreads in the sovereign bond market. Over time, there is an increase in “home bias” – greater exposure of domestic banks to its sovereign’s bonds – which is partly explained by the European Central Bank funding of these positions. On balance, our results are supportive of moral hazard in the form of risk-taking by under-capitalized banks to exploit low risk weights and central-bank funding of risky government bond positions.
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Bibliographic InfoPaper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 9432.
Date of creation: Apr 2013
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Find related papers by JEL classification:
- F3 - International Economics - - International Finance
- G01 - Financial Economics - - General - - - Financial Crises
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
- G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
This paper has been announced in the following NEP Reports:
- NEP-ALL-2013-09-24 (All new papers)
- NEP-BAN-2013-09-24 (Banking)
- NEP-EEC-2013-09-24 (European Economics)
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