The 'Greatest' Carry Trade Ever? Understanding Eurozone Bank Risks
51 Pages Posted: 29 Apr 2013 Last revised: 30 Sep 2015
Date Written: November 2, 2014
We show that eurozone bank risks during 2007-2013 can be understood as carry trade behavior. Bank equity returns load positively on peripheral (Greece, Italy, Ireland, Portugal, Spain, or GIIPS) bond returns and negatively on German government bond returns, which generated carry until the deteriorating GIIPS bond returns adversely affected bank balance sheets. We find support for risk-shifting and regulatory arbitrage motives at banks in that carry trade behavior is stronger for large banks and banks with low capital ratios and high risk-weighted assets. We also find evidence for home bias and moral suasion in the subsample of GIIPS banks.
Keywords: Sovereign debt crisis, banking crisis, risk-shifting, regulatory arbitrage, home bias
JEL Classification: G01, G21, G28, G14, G15, F3
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