Kicking the Can Down the Road: Government Interventions in the European Banking Sector

Abstract

We analyze the determinants and the long-run consequences of government interventions in the eurozone banking sector during the 2008/09 financial crisis. Using a novel and comprehensive dataset, we document that fiscally constrained governments "kicked the can down the road" by providing banks with guarantees instead of full-fledged recapitalizations. We adopt an econometric approach that addresses the endogeneity associated with governmental bailout decisions in identifying their consequences. We find that forbearance caused undercapitalized banks to shift their assets from

loans to risky sovereign debt and engage in zombie lending, resulting in weaker credit supply, elevated risk in the banking sector, and, eventually, greater reliance on liquidity support from the European Central Bank.

Keywords: Bank Recapitalization, evergreening, fiscal constraints, Forbearance, political economy, sovereign debt crisis, zombie lending

JEL Classification: E44, G21, G28, G32, G34