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A Pyrrhic Victory? - Bank Bailouts and Sovereign Credit Risk

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  • Viral V. Acharya
  • Itamar Drechsler
  • Philipp Schnabl

Abstract

We show that financial sector bailouts and sovereign credit risk are intimately linked. A bailout benefits the economy by ameliorating the under-investment problem of the financial sector. However, increasing taxation of the non-financial sector to fund the bailout may be inefficient since it weakens its incentive to invest, decreasing growth. Instead, the sovereign may choose to fund the bailout by diluting existing government bondholders, resulting in a deterioration of the sovereign's creditworthiness. This deterioration feeds back onto the financial sector, reducing the value of its guarantees and existing bond holdings and increasing its sensitivity to future sovereign shocks. We provide empirical evidence for this two-way feedback between financial and sovereign credit risk using data on the credit default swaps (CDS) of the Eurozone countries for 2007-10. We show that the announcement of financial sector bailouts was associated with an immediate, unprecedented widening of sovereign CDS spreads and narrowing of bank CDS spreads; however, post-bailouts there emerged a significant co-movement between bank CDS and sovereign CDS, even after controlling for banks' equity performance, the latter being consistent with an effect of the quality of sovereign guarantees on bank credit risk.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17136.

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Date of creation: Jun 2011
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Publication status: published as “A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk” with Itamar Drechsler and Philipp Schnabl, forthcoming, Journal of Finance.
Handle: RePEc:nbr:nberwo:17136

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  1. Viral Acharya & Tanju Yorulmazer, 2007. "Too many to fail - an analysis of time-inconsistency in bank closure policies," Bank of England working papers 319, Bank of England.
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