A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk

TLDR

We model a loop in which distressed banks trigger government bailouts that raise sovereign credit risk, which in turn weakens banks by eroding the value of their government debt guarantees and bond holdings. Using European sovereign and bank CDS data from 2007‑11, we find that bailouts increased sovereign credit risk and that post‑bailout sovereign CDS changes explain bank CDS changes even after controlling for other determinants, confirming the sovereign‑bank loop.

Abstract

We model a loop between sovereign and bank credit risk. A distressed financial sector induces government bailouts, whose cost leads to increased sovereign credit risk. Increased sovereign credit risk in turn weakens the financial sector by eroding the value of its government debt guarantees and bond holdings. Using credit default swaps (CDS) rates on European sovereigns and banks for 2007-11, we show that bailouts triggered the rise of sovereign credit risk. 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.