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http://hdl.handle.net/2451/31331
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| Title: | A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk |
| Authors: | Acharya, Viral V.
Drechsler, Itamar
Schnabl, Philipp |
| Issue Date: | 30-Nov-2011 |
| Series/Report no.: | FIN-11-011 |
| Abstract: | We show that nancial sector bailouts and sovereign credit risk are
intimately linked. A bailout benets the economy by ameliorating the
under-investment problem of the nancial sector. However, increasing
taxation of the non-nancial sector to fund the bailout may be inecient
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 to the nancial sector,
reducing the value of its guarantees and existing bond holdings as well
as increasing its sensitivity to future sovereign shocks. We provide
empirical evidence for this two-way feedback between nancial and
sovereign credit risk using data on the credit default swaps (CDS) of
the Eurozone countries and their banks for 2007-11. We show that the
announcement of nancial 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 signi- cant
co-movement between bank CDS and sovereign CDS, even after controlling
for banks' equity performance, the latter being consistent with an eect
of the quality of sovereign guarantees on bank credit risk. |
| URI: | http://hdl.handle.net/2451/31331 |
| Appears in Collections: | Finance Working Papers
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