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A Pyrrhic Victory? - Bank Bailouts and Sovereign Credit Risk

  • Viral V. Acharya
  • Itamar Drechsler
  • Philipp Schnabl

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
Note: AP CF IFM
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  2. Nicola Gennaioli & Alberto Martin & Stefano Rossi, 2009. "Sovereign default, domestic banks and financial institutions," Economics Working Papers 1170, Department of Economics and Business, Universitat Pompeu Fabra, revised Feb 2012.
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  14. Gary Gorton & Lixin Huang, 2002. "Liquidity, Efficiency and Bank Bailouts," Center for Financial Institutions Working Papers 02-33, Wharton School Center for Financial Institutions, University of Pennsylvania.
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  17. Viral V. Acharya & Hyun Song Shin & Tanju Yorulmazer, 2011. "Crisis Resolution and Bank Liquidity," Review of Financial Studies, Society for Financial Studies, vol. 24(6), pages 2166-2205.
  18. Stavros Panageas, 2009. "Optimal taxation in the presence of bailouts," NBER Working Papers 15405, National Bureau of Economic Research, Inc.
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  20. Ejsing, Jacob & Lemke, Wolfgang, 2009. "The Janus-headed salvation: sovereign and bank credit risk premia during 2008-09," Working Paper Series 1127, European Central Bank.
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