A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk

59 Pages Posted: 26 Jun 2013

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)

Multiple version iconThere are 4 versions of this paper

Date Written: November 2011

Abstract

We show that nancial sector bailouts and sovereign credit risk are intimately linked. A bailout benets the economy by ameliorating the under-investment problem of the nancial sector. However, increasing taxation of the non-nancial sector to fund the bailout may be inecient since it weakens its incentive to invest, decreasing growth. Instead, the sovereign may choose to fund the bailout by diluting existing government bondholders, resulting in a deterioration of the sovereign's creditworthiness. This deterioration feeds back to the nancial sector, reducing the value of its guarantees and existing bond holdings as well as increasing its sensitivity to future sovereign shocks. We provide empirical evidence for this two-way feedback between nancial and sovereign credit risk using data on the credit default swaps (CDS) of the Eurozone countries and their banks for 2007-11. We show that the announcement of nancial sector bailouts was associated with an immediate, unprecedented widening of sovereign CDS spreads and narrowing of bank CDS spreads; however, post-bailouts there emerged a signi- cant co-movement between bank CDS and sovereign CDS, even after controlling for banks' equity performance, the latter being consistent with an eect of the quality of sovereign guarantees on bank credit risk.

Suggested Citation

Acharya, Viral V. and Acharya, Viral V. and Drechsler, Itamar and Schnabl, Philipp, A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk (November 2011). NYU Working Paper No. 2451/31331, Available at SSRN: https://ssrn.com/abstract=2284650

Viral V. Acharya (Contact Author)

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

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States
2129980354 (Phone)
2129954256 (Fax)

HOME PAGE: http://www.stern.nyu.edu/~vacharya

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

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

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Itamar Drechsler

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

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
69
Abstract Views
5,354
Rank
57,397
PlumX Metrics