A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
64 Pages Posted: 17 May 2012 Last revised: 17 May 2013
Date Written: April 4, 2013
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
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