Am I Riskier If I Rescue My Banks? The Unintended Effects of Bailouts

Abstract

We examine the relationship between bank bailouts and sovereign risk in 35 countries and 19 bailouts during 2005–2015. Bailouts negatively affect sovereign ratings, with rating agencies consistently perceiving higher risk when the country’s banking system has been rescued (risk-increasing effect). Financial soundness and banking market structure shape the impact of bailouts on sovereign risk. In particular, proactiveness in undertaking public bailouts for banking systems that are largely distressed -risky and low profitable- and highly concentrated seems to lead to lower increases in sovereign risk. However, the strength of the connection between the public sector and the banking system neither moderates nor magnifies the impact of bailouts. Moreover, ratings dynamics (duration, momentum, timing) are found to be affected by bailouts revealing that the effects of bailouts on ratings are not short-lived. Results are robust to endogeneity concerns, sample selection bias and several robustness tests.

Keywords: Bank bailouts; Sovereign risk; Risk-increasing effect; Banking sector characteristics

JEL Classification: G01; G21; G24; H63