Moral Hazard and Bail-Out in Fiscal Federations: Evidence for the German Länder

48 Pages Posted: 8 Jun 2016

See all articles by Kirsten Heppke-Falk

Kirsten Heppke-Falk

Deutsche Bundesbank

Guntram B. Wolff

Deutsche Bundesbank; University of Bonn - Center for European Integration Studies (ZEI)

Multiple version iconThere are 2 versions of this paper

Date Written: 2007

Abstract

We identify investor moral hazard in the German fiscal federation. Our identification strategy is based on a variable, which was used by the German Federal Constitutional Court as an indicator to determine eligibility of two German states (Länder) to a bail-out, the interest payments-to-revenue ratio. While risk premia measured in the German sub-national bond market react significantly to the relative debt level of a state (Land), we also find that a larger interest payments-to-revenue ratio counter-intuitively lowers risk premia significantly. Furthermore, with increasing values the risk premia decrease more strongly. This is evidence of investor moral hazard, because a larger indicator value increases the likelihood of receiving a bail-out payment. Quantitatively, the effects are, however, quite small. Our findings are robust to a variety of sample changes. In addition, we provide a case study of the recent Federal Constitutional Court ruling on the Land Berlin, which had filed for additional federal funds. The negative response of the court did not lead to a change in financial markets' bail-out expectations. In sum, our results indicate significant investor moral hazard in the sub-national German bond market.

Keywords: moral hazard, bail-out, sovereign bond spreads, fiscal federalism, Germany

JEL Classification: F34, H6, H7, G14, G15, E62

Suggested Citation

Heppke-Falk, Kirsten and Wolff, Guntram B., Moral Hazard and Bail-Out in Fiscal Federations: Evidence for the German Länder (2007). Bundesbank Series 1 Discussion Paper No. 2007,07, Available at SSRN: https://ssrn.com/abstract=2785282

Kirsten Heppke-Falk (Contact Author)

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

Guntram B. Wolff

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

University of Bonn - Center for European Integration Studies (ZEI) ( email )

Regina-Pacis-Weg 3
Postfach 2220
D-53012 Bonn
Germany

HOME PAGE: http://www.uni-bonn.de/~guntram

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