Bank Bailouts and Sovereign Credit Risk - Carlson School

A Pyrrhic Victory? – 1 Bank Bailouts and Sovereign Credit Risk 2 3 Viral V. Acharya Itamar Drechsler NYU-Stern, CEPR and NBER NYU-Stern 4 Philipp Schnabl NYU-Stern J.E.L. Classification: G21, G28, G38, E58, D62. Keywords: financial crises, forbearance, deleveraging, sovereign debt, growth, credit default swaps First draft: August 2010; This draft: 6 December 2010 Preliminary and Incomplete 1 We are grateful to Isabel Schnabel (discussant) and seminar participants at Austrian Central Bank for helpful comments. Farhang Farazmand and Nirupama Kulkarni provided valuable research assistance. 2 Contact: Department of Finance, Stern School of Business, New York University, e-mail: vacharya@stern.nyu.edu. Acharya is also a Research Affiliate of the Centre for Economic Pol- icy Research (CEPR) and a Research Associate at the National

Bureau of Economic Research (NBER). 3 Contact: Department of Finance, Stern School of Business, New York University e-mail: Ita- mar.Drechsler@stern.nyu.edu. 4 Contact: Department of Finance, Stern School of Business, New York University e-mail: pschn- abl@stern.nyu.edu. A Pyrrhic Victory? – Bank Bailouts and Sovereign Credit Risk Abstract We develop a model in which financial sector bailout and sovereign credit risk are inti- mately linked. The bailout ameliorates the under-investment problem of the financial sector. However, as the bailout is ultimately funded through taxation of the future profits of the non-financial sectors, it weakens their incentives to invest. This can adversely affect the sovereign’s own credit risk which severely limits the size of the efficient bailout. In the short-run, the bailout is funded through issuance of government bonds, which erodes the value of existing bonds, including those held by the financial sector and potentially creates a “crisis spiral”. The model provides testable implications concerning the relation between the credit risk of the sovereign and its financial sector before the crisis, around the bailout announcement, and post-bailout. We provide supporting empirical evidence using data from the credit default swaps (CDS) market around the bailouts and bank stress tests conducted during the financial and sovereign crises of 2007-10. J.E.L. Classification: G21, G28, G38, E58, D62. Keywords: financial crises, forbearance, deleveraging, sovereign debt, growth, credit de- fault swaps 1 1 Introduction On September 30, 2008 the government of Ireland announced that it had guaranteed all deposits of the six of its biggest banks. The immediate reaction that grabbed newspaper headlines the next day was whether such a policy of a full savings guarantee was anti- competitive in the Euro area. However, there was something deeper manifesting itself in the credit default swap (CDS) markets for purchasing protection against the sovereign credit risk of Ireland and that of its banks. Figure 1 shows that while the cost of purchasing such protection on Irish banks – their CDS fee – fell overnight from around 400 basis points to 150 basis points, the CDS fee for the Government of Ireland’s credit risk rose sharply. Over the next month, this rate more than quadrupled to over 100 basis points and within six months reached 400 basis points, the starting level of its financial firms’ CDS. While there was a general deterioration of global economic health over this period, the event-study response in Figure 1 makes it clear that the...

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