A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk

We model a loop between sovereign and bank credit risk. A distressed financial sector induces government bailouts, whose cost increases sovereign credit risk. Increased sovereign credit risk in turn weakens the financial sector by eroding the value of its government guarantees and bond holdings. Usi...

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Bibliographic Details
Published in:The Journal of finance (New York) 2014-12, Vol.69 (6), p.2689-2739
Main Authors: ACHARYA, VIRAL, DRECHSLER, ITAMAR, SCHNABL, PHILIPP
Format: Article
Language:English
Subjects:
Bailouts
Bank assets
Bank credit
Banking crises
Banks
Credit default swaps
Credit market
Credit risk
Debt
Economic models
Europe
Financial bailouts
Financial management
Financial services
Financial theory
Government bonds
Risk theory
Sovereign debt
Studies
Tax revenues
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Summary:We model a loop between sovereign and bank credit risk. A distressed financial sector induces government bailouts, whose cost increases sovereign credit risk. Increased sovereign credit risk in turn weakens the financial sector by eroding the value of its government guarantees and bond holdings. Using credit default swap (CDS) rates on European sovereigns and banks, we show that bailouts triggered the rise of sovereign credit risk in 2008. We document that post-bailout changes in sovereign CDS explain changes in bank CDS even after controlling for aggregate and bank-level determinants of credit spreads, confirming the sovereign-bank loop.
ISSN:0022-1082
1540-6261
DOI:10.1111/jofi.12206