A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk

Acharya, Viral V.; Drechsler, Itamar; Schnabl, Philipp

doi:10.2139/ssrn.1865465

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A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk

Journal of Finance, Forthcoming

69 Pages Posted: 19 Jun 2011 Last revised: 14 Jan 2014

See all articles by Viral V. Acharya

Viral V. Acharya

New York University (NYU) - Leonard N. Stern School of Business; New York University (NYU) - Department of Finance; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); National Bureau of Economic Research (NBER)

Itamar Drechsler

Wharton School, Department of Finance; National Bureau of Economic Research (NBER)

Philipp Schnabl

New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

There are 4 versions of this paper

Date Written: December 10, 2013

Abstract

We model a loop between sovereign and bank credit risk. A distressed financial sector induces government bailouts, whose cost leads to increased sovereign credit risk. Increased sovereign credit risk in turn weakens the financial sector by eroding the value of its government debt guarantees and bond holdings. Using credit default swaps (CDS) rates on European sovereigns and banks for 2007-11, we show that bailouts triggered the rise of sovereign credit risk. We document that post-bailout changes in sovereign CDS explain changes in bank CDS even after controlling for aggregate and bank-level determinants of credit spreads, confirming the sovereign-bank loop.

Keywords: Financial Crises, Sovereign Debt, Credit Default Swaps

JEL Classification: G21, G28, G38, E58, D62

Suggested Citation: Suggested Citation

Acharya, Viral V. and Acharya, Viral V. and Drechsler, Itamar and Schnabl, Philipp, A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk (December 10, 2013). Journal of Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1865465 or http://dx.doi.org/10.2139/ssrn.1865465