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A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk

Author

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  • Acharya, Viral
  • Schnabl, Philipp
  • Drechsler, Itamar
Abstract
We show that financial sector bailouts and sovereign credit risk are intimately linked. A bailout benefits the economy by ameliorating the under-investment problem of the financial sector. However, increasing taxation of the non-financial sector to fund the bailout may be inefficient 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 financial 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 financial 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 financial 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 significant co-movement between bank CDS and sovereign CDS, even after controlling for banks' equity performance, the latter being consistent with an effect of the quality of sovereign guarantees on bank credit risk.

Suggested Citation

  • Acharya, Viral & Schnabl, Philipp & Drechsler, Itamar, 2011. "A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk," CEPR Discussion Papers 8679, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:8679
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    More about this item

    Keywords

    Financial crises; Forbearance; Deleveraging; Sovereign debt; Growth; Credit default swaps;
    All these keywords.

    JEL classification:

    • D62 - Microeconomics - - Welfare Economics - - - Externalities
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation

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