Working Paper: CEPR ID: DP8679
Authors: Viral V. Acharya; Itamar Drechsler; Philipp Schnabl
Abstract: 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 to the financial 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 financial 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 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.
Keywords: financial crises; forbearance; deleveraging; sovereign debt; growth; credit default swaps
JEL Codes: D62; E58; G21; G28; G38
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial sector bailouts (G28) | sovereign credit risk (F34) |
| increased taxation on the non-financial sector (H29) | reduced investment incentives (G31) |
| reduced investment incentives (G31) | overall growth (O40) |
| government dilutes existing bondholders (H74) | deteriorating creditworthiness (G32) |
| sovereign credit risk (F34) | financial sector credit risk (G21) |
| bailouts (H81) | increased taxation (H29) |
| bailouts (H81) | bank CDS spreads (G21) |
| sovereign credit risk (F34) | bank credit risk (G21) |
| bank CDS spreads (G21) | sovereign CDS spreads (F34) |