Working Paper: NBER ID: w19039
Authors: Viral V. Acharya; Sascha Steffen
Abstract: We show that Eurozone bank risks during 2007-2012 can be understood as a "carry trade" behavior. Bank equity returns load positively on peripheral (Greece, Ireland, Portugal, Spain and Italy, or GIPSI) bond returns and negatively on German government bond returns, a position that generated "carry" until the deteriorating GIPSI bond returns inflicted losses on banks. The positive GIPSI loadings correlate with banks' holdings of GIPSI bonds; and, the negative German loading with banks' short-term debt exposures. Consistent with moral hazard in the form of risk-taking by large, under-capitalized banks to exploit government guarantees, arbitrage regulatory risk weights, and access central-bank funding, we find that this carry-trade behavior is stronger for large banks, and banks with low Tier 1 ratios and high risk-weighted assets, in both GIPSI and non-GIPSI countries' banks, but not so for similar banks in other Western economies or for non-bank firms.
Keywords: Eurozone; Bank Risks; Carry Trade
JEL Codes: F3; G01; G14; G15; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Regulatory capital arbitrage (G18) | increased risk-taking behavior (D91) |
| Lower Tier 1 ratios (G32) | higher exposure to GIPSIs (P34) |
| Higher risk-weighted assets (G21) | higher exposure to GIPSIs (P34) |
| Carry trade behavior (G15) | positive correlation between bank equity returns and GIPSIs (F65) |
| Carry trade behavior (G15) | negative correlation with German bund returns (G12) |
| Excessive risk due to moral hazard (G52) | significant losses when GIPSIs deteriorated (P27) |
| Undercapitalized banks (G21) | more likely to engage in riskier strategies (G40) |
| Larger banks (G21) | more pronounced carry trade behavior (G15) |