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

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

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. Copyright 2008 The Authors. Journal compilation 2008 Blackwell Publishing Ltd.

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Article provided by Wiley Blackwell in its journal Kyklos.

Volume (Year): 61 (2008)
Issue (Month): 3 (08)
Pages: 425-446

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Handle: RePEc:bla:kyklos:v:61:y:2008:i:3:p:425-446
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