A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk

We show that nancial sector bailouts and sovereign credit risk are intimately linked. A bailout benets the economy by ameliorating the under-investment problem of the nancial sector. However, increasing taxation of the non-nancial sector to fund the bailout may be inecient 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 nancial 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 nancial 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 nancial 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 signi- cant co-movement between bank CDS and sovereign CDS, even after controlling for banks' equity performance, the latter being consistent with an eect of the quality of sovereign guarantees on bank credit risk