A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk

64 Pages Posted: 17 May 2012 Last revised: 17 May 2013

See all articles by Viral V. Archarya

Viral V. Archarya

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

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 4, 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 sector bailouts, sovereign credit risk

Suggested Citation

Archarya, Viral V. and Drechsler, Itamar and Schnabl, Philipp, A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk (April 4, 2013). Available at SSRN: https://ssrn.com/abstract=2061052 or http://dx.doi.org/10.2139/ssrn.2061052

Viral V. Archarya (Contact Author)

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

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Suite 9-160
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Itamar Drechsler

Wharton School, Department of Finance ( email )

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Philadelphia, PA 19104-6365
United States

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

National Bureau of Economic Research (NBER) ( email )

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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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