A Tale of Two Overhangs: The Nexus of Financial Sector and Sovereign Credit Risks

Financial Stability Review, No. 16, April 2012

6 Pages Posted: 29 Apr 2012

See all articles by Viral V. Acharya

Viral V. Acharya

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

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)

Date Written: April 2012

Abstract

There has emerged in the Western economies a strong nexus between the credit risks of financial sectors and their sovereigns. We argue that this phenomenon can be understood in the context of two debt overhang problems: one affecting the financial sector due to its under-capitalization following the crisis of 2007-08; the second, affecting the non-financial sector, whose incentives are crowded out by high sovereign debt and anticipated future taxes. While the desire to resolve the financial sector overhang may make bailouts tempting, they raise the risk of exacerbating the overhang related to sovereign debt. Conversely, reduction of growth prospects due to sovereign debt overhang can make the financial sector riskier as it is highly exposed to sovereign debt both through direct holdings and indirectly through implicit government guarantees. We provide evidence on this important nexus, based on our ongoing research that exploits data on European bank and sovereign credit risks.

Keywords: Sovereign Debt, Financial Crisis, Bailouts, Debt Overhang, Credit Default Swaps

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

Suggested Citation

Acharya, Viral V. and Drechsler, Itamar and Schnabl, Philipp, A Tale of Two Overhangs: The Nexus of Financial Sector and Sovereign Credit Risks (April 2012). Financial Stability Review, No. 16, April 2012. Available at SSRN: https://ssrn.com/abstract=2047601

Viral V. Acharya

New York University - Leonard N. Stern School of Business ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States

HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Itamar Drechsler (Contact Author)

Wharton School, Department of Finance ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

HOME PAGE: http://https://sites.google.com/site/idrechsl/

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Philipp Schnabl

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

HOME PAGE: http://pages.stern.nyu.edu/~sternfin/pschnabl/

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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