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Moral hazard and bail-out in fiscal federations: evidence for the German Länder

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

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. Quantitatively, the effects are, however, quite small. 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.

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Paper provided by Deutsche Bundesbank, Research Centre in its series Discussion Paper Series 1: Economic Studies with number 2007,07.

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Date of creation: 2007
Date of revision:
Handle: RePEc:zbw:bubdp1:5561
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