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Moral Hazard and Bail‐Out in Fiscal Federations: Evidence for the German Länder

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  • Kirsten H. Heppke‐Falk
  • Guntram B. Wolff

Abstract

We identify investor moral hazard in the German fiscal federation. Our identification strategy is based on a variable, which was used by the German Federal Constitutional Court as an indicator to determine eligibility of two German states (Länder) to a bail‐out, the interest payments‐to‐revenue ratio. While risk premia measured in the German sub‐national bond market react significantly to the relative debt level of a state (Land), we also find that a larger interest payments‐to‐revenue ratio counter‐intuitively lowers risk premia significantly. Furthermore, with increasing values the risk premia decrease more strongly. This is evidence of investor moral hazard, because a larger indicator value increases the likelihood of receiving a bail‐out payment. Our findings are robust to a variety of sample changes. In addition, we provide a case study of the recent Federal Constitutional Court ruling on the Land Berlin, which had filed for additional federal funds. The negative response of the court did not lead to a change in financial markets' bail‐out expectations. In sum, our results indicate significant investor moral hazard in the sub‐national German bond market.

Suggested Citation

  • Kirsten H. Heppke‐Falk & Guntram B. Wolff, 2008. "Moral Hazard and Bail‐Out in Fiscal Federations: Evidence for the German Länder," Kyklos, Wiley Blackwell, vol. 61(3), pages 425-446, August.
  • Handle: RePEc:bla:kyklos:v:61:y:2008:i:3:p:425-446
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    File URL: https://doi.org/10.1111/j.1467-6435.2008.00411.x
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    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • H6 - Public Economics - - National Budget, Deficit, and Debt
    • H7 - Public Economics - - State and Local Government; Intergovernmental Relations
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy

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