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Bank Bailouts and Sovereign Credit Risk

1

Viral V. Acharya

2

NYU-Stern, CEPR and NBER

Itamar Drechsler

3

NYU-Stern

Philipp Schnabl

4

NYU-Stern and CEPR

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: May 2011

1

We are grateful to Isabel Schnabel and Luigi Zingales (discussants), Dave Backus, Mike Cher-

nov, Amir Yaron, Stan Zin, and seminar participants at Austrian Central Bank, AEA Meetings

(2011), HEC Paris and BNP Paribas Hedge Fund Center conference, Bundesbank-ECB-CFS Joint

Luncheon workshop, Federal Reserve Bank of Minneapolis, Oxford Said Business School, Univer-

sity of Minnesota, Indian School of Business, Indian Institute of Management (Ahmedabad), and

Douglas Gale’s Financial Economics workshop at NYU Economics for helpful comments. Farhang

Farazmand and Nirupama Kulkarni provided valuable research assistance.

2

Department of Finance, Stern School of Business, New York University, e-mail:

vacharya@stern.nyu.edu

3

Department of Finance, Stern School of Business, New York University, e-mail: ita-

mar.drechsler@stern.nyu.edu.

4

Department of Finance, Stern School of Business, New York University, e-mail: schn-

abl@stern.nyu.edu.

A Pyrrhic Victory? –

Bank Bailouts and Sovereign Credit Risk

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 corporate 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 onto the

ﬁnancial sector, reducing the value of its guarantees and existing bond holdings and increas-

ing 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 for 2007-10. 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 signif-

icant 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.

J.E.L. Classiﬁcation: G21, G28, G38, E58, D62.

Keywords: ﬁnancial crises, forbearance, deleveraging, sovereign debt, growth, credit de-

fault swaps

1

1 Introduction

Just two and a half years ago, there was essentially no sign of sovereign credit risk in the

developed economies and a prevailing view was that this was unlikely to be a concern for them

in the near future. Recently, however, sovereign credit risk has become a signiﬁcant problem

for a number of developed countries. In this paper, we are motivated by three closely related

questions surrounding this development. First, were the ﬁnancial sector bailouts an integral

factor in igniting the rise of sovereign credit risk in the developed economies? We show that

they were. Second, what was the exact mechanism that caused the transmission of risks

between the ﬁnancial sector and the sovereign? We propose a theoretical explanation wherein

the government can ﬁnance a bailout through both increased taxation and via dilution of

existing government debt-holders. The bailout is beneﬁcial; it alleviates a distortion in

the provision of ﬁnancial services. However, both ﬁnancing channels are costly. When

the optimal bailout is large, dilution can become a relatively attractive option, leading

to deterioration in the sovereign’s creditworthiness. Finally, we ask whether there is also

feedback going in the other direction– does sovereign credit risk feedback on to the ﬁnancial

sector? We explain – and verify empirically – that such a feedback is indeed present, due to

the ﬁnancial sector’s implicit and explicit holdings of sovereign bonds.

Our results call into question the usually implicit assumption that government resources

are vastly deep and that the main problem posed by bailouts is primarily that of moral

hazard – that is, the distortion of future ﬁnancial sector incentives. While the moral hazard

cost is certainly pertinent, our conclusion is that bailout costs are not just in the future.

They are tangible right around the timing of bailouts and are priced into the sovereign’s

credit risk and cost of borrowing. Thus, aggressive bailout packages that stabilize ﬁnancial

sectors in the short run but ignore the ultimate taxpayer cost might end up being a Pyrrhic

victory.

Motivation: The case of Irish bailout. 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

2

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 suggests that the risk of the ﬁnancial

sector had been substantially transferred to the government balance sheet, a cost that Irish

taxpayers must eventually bear.

Viewed in the Fall of 2010, this cost rose to dizzying heights prompting economists

to wonder if the precise manner in which bank bailouts were awarded have rendered the

ﬁnancial sector rescue exorbitantly expensive. Just one of the Irish banks, Anglo Irish, has

cost the government up to Euro 25 bln (USD 32 bln), amounting to 11.26% of Ireland’s Gross

Domestic Product (GDP). Ireland’s ﬁnance minister Brian Lenihan justiﬁed the propping up

of the bank “to ensure that the resolution of debts does not damage Ireland’s international

credit-worthiness and end up costing us even more than we must now pay.” Nevertheless,

rating agencies and credit markets revised Ireland’s ability to pay future debts signiﬁcantly

downward. The original bailout cost estimate of Euro 90 bln was re-estimated to be 50%

higher and the Irish 10-year bond spread over German bund widened signiﬁcantly, ultimately

leading to a bailout of Irish government by the stronger Eurozone countries.

1

This episode is not isolated to Ireland though it is perhaps the most striking case. In

fact, a number of Western economies that bailed out their banking sectors in the Fall of

2008 have experienced, in varying magnitudes, similar risk transfer between their ﬁnancial

sector and government balance-sheets. Our paper develops a theoretical model and provides

empirical evidence that help understand this interesting phenomenon.

Model. Our theoretical model consists of two sectors of the economy – “ﬁnancial” and

“corporate” (more broadly this includes also the household and other non-ﬁnancial parts of

the economy), and a government. The two sectors contribute jointly to produce aggregate

output: the corporate sector makes productive investments and the ﬁnancial sector invests in

intermediation “eﬀort” (e.g., information gathering and capital allocation) that enhance the

return on corporate investments. Both sectors, however, face a potential under-investment

problem. The ﬁnancial sector is leveraged (in a crisis, it may in fact be insolvent) and under-

invests in its contributions due to the well-known debt overhang problem (Myers, 1977).

For simplicity, the corporate sector is un-levered. However, if the government undertakes a

1

See “Ireland’s banking mess: Money pit – Austerity is not enough to avoid scrutiny by the markets”,

the Economist, Aug 19th 2010; “S&P downgrades Ireland” by Colin Barr, CNNMoney.com, Aug 24th 2010;

and, “Ireland stung by S&P downgrade”, Reuters, Aug 25th, 2010.

3

“bailout” of the ﬁnancial sector, in other words, makes a transfer from the rest of the economy

that results in a net reduction of the ﬁnancial sector debt, then the transfer must be funded

in the future (at least in part) through taxation of corporate proﬁts. Such taxation, assumed

to be proportional to corporate sector output, induces the corporate sector to under-invest.

A government that is fully aligned with maximizing the economy’s current and future

output determines the optimal size of the bailout. We show that tax proceeds that can

be used to fund the bailout have, in general, a Laﬀer curve property, so that the optimal

bailout size and tax rate are interior. The optimal tax rate that the government is willing to

undertake for the bailout is greater when the ﬁnancial sector’s debt overhang is higher and

its relative contribution (or size) in output of the economy is larger.

In practice, governments fund bailouts in the short run by borrowing or issuing bonds,

which are repaid by future taxation. There are two interesting constraints on the bailout size

that emerge from this observation. One, the greater is the legacy debt of the government, the

lower is its ability to undertake a bailout. This is because the Laﬀer curve of tax proceeds

leaves less room for the government to increase tax rates for repaying its bailout-related

debt. Second, the announcement of the bailout lowers the price of government debt due to

the anticipated dilution from newly issued debt. Now, if the ﬁnancial sector of the economy

has assets in place that are in the form of government bonds, the bailout is in fact associated

with some “collateral damage” for the ﬁnancial sector itself. Illustrating the possibility of

such a two-way feedback is a novel contribution of our model.

To get around these constraints, the government can potentially undertake a strategic

default. Assuming that there are some deadweight costs of such default, for example, due

to international sanctions or from being unable to borrow in debt markets for some time,

we derive the optimal boundary for sovereign default as a function of its legacy debt and

ﬁnancial sector liabilities. This boundary explains that a heavily-indebted sovereign faced

with a heavily-insolvent ﬁnancial sector will be forced to “sacriﬁce its credit rating” to save

the ﬁnancial sector and at the same time sustain economic growth.

We then extend the model to allow for uncertainty about the realized output growth of

the corporate sector.This introduces a possibility of solvency-based default on government

debt. Interestingly, given the collateral damage channel, an increase in uncertainty about

the sovereign’s economic output not only lowers its own debt values but also increases the

ﬁnancial sector’s risk of default. This is because the ﬁnancial sector’s government bond

holdings fall in value, and in an extension of the model, so do the value of the government

guarantees accorded to the ﬁnancial sector as a form of bailout. In turn, these channels

4

induce a post-bailout co-movement between the ﬁnancial sector’s credit risk and that of the

sovereign, even though the immediate eﬀect of the bailout is to lower the ﬁnancial sector’s

credit risk and raise that of the sovereign.

Empirics. Our empirical work analyzes this two-way feedback between the ﬁnancial sector

and sovereign credit risk. Our analysis focuses mainly on the Western European economies

during the ﬁnancial crisis of 2007-10.

In our non-parametric analysis, we examine sovereign and bank CDS in the period from

2007 to 2010 and ﬁnd three distinct periods. The ﬁrst period covers the start of the ﬁnan-

cial crisis in January 2007 until the bankruptcy of Lehman Brothers. Across all Western

economies, we see a large, sustained rise in bank CDS as the ﬁnancial crisis develops. How-

ever, sovereign CDS spreads remains very low. This evidence is consistent with a signiﬁcant

increase in the default risk of the banking sector with little eﬀect on sovereigns in the pre-

bailout period.

The second period covers the bank bailouts starting with the announcement of a bailout

in Ireland in late September 2008 and ending with a bailout in Sweden in late October 2008.

During this one-month period, we ﬁnd a signiﬁcant decline in bank CDS across all countries

and a corresponding increase in sovereign CDS. This evidence suggests that bank bailouts

produced a transfer of default risk from the banking sector to the sovereign.

The third period covers the period after the bank bailouts and until 2010. We ﬁnd that

both sovereign and bank CDS increased during this period and that the increase was larger

for countries with signiﬁcant public debt ratios. This evidence suggests that the banks and

sovereigns share the default risk after the announcement of banks bailouts and that the risk

is increasing in the relative size of countries’ public debt.

We conﬁrm all of the above results also in our regression analysis linking levels and

changes in ﬁnancial sector CDS to levels and changes, respectively, of sovereign CDS in

the three periods. We also conﬁrm model’s implications that banks with higher leverage

experience a stronger relationship between sovereign and bank credit risks after the bailouts.

Finally, in support of the collateral damage channel as being potentially relevant for

the co-movement between ﬁnancial sector and sovereign CDS, we collect bank-level data on

holdings of diﬀerent sovereign government bonds released as part of the bank stress tests

conducted for European banks in 2010. We document that on average Eurozone banks

stress-tested in 2010 held Eurozone government bond holdings that were as large as one-

sixth of their risk-weighted assets. Consistent with the economic importance of the collateral

damage channel, we show that bank CDS co-move with sovereign CDS on banks’ holdings

5

of government bonds.

The remainder of the paper is organized as follows. Section 2 presents our theoretical

analysis. Section 4 provides empirical evidence. Section 5 discusses the related literature.

Section 6 concludes. All proofs not in the main text are in the online Appendix.

2 Model

There are three time periods in the model: t = 0, 1, and 2. The productive economy consists

of two parts, a ﬁnancial sector and a non-ﬁnancial sector. In addition, there is a government

and a representative consumer. All agents are risk-neutral.

Financial sector: The operator of the ﬁnancial sector solves the following problem, which

is to choose, at t = 0, the amount of ﬁnancial services to supply at t = 1 in order to maximize

his expected payoﬀ at t = 1, net of the eﬀort cost required to produce these services:

max

s

s

0

E

0

__

w

s

s

s

0

−L

1

+

˜

A

1

+A

G

+T

0

_

×1

{−L

1

+

˜

A

1

+A

G

+T

0

>0}

_

−c(s

s

0

) . (1)

where s

s

0

is the amount of ﬁnancial services supplied by the ﬁnancial sector at t = 1. The

ﬁnancial sector earns revenues at the rate of w

s

per unit of ﬁnancial service supplied, with w

s

determined in equilibrium. To produce s

0

units, the operator of the ﬁnancial sector expends

c(s

0

) units of eﬀort. We assume that c

(s

0

) > 0 and c

(s

0

) > 0.

The ﬁnancial sector has both liabilities and assets on its books. It receives the payoﬀ

from its eﬀorts only if the value of assets exceeds liabilities at t = 1. This solvency condition

is given in equation (1) by the indicator function for the expression −L

1

+

˜

A

1

+A

G

+T

0

> 0.

L

1

denotes the liabilities of the ﬁnancial sector, which are due (mature) at t = 1. There

are two types of assets held by the ﬁnancial sector, denoted

˜

A

1

and A

G

. A

G

is the value of

the ﬁnancial sector’s holdings of a fraction k

A

of outstanding government bonds, while

˜

A

1

represents the payoﬀ of the other assets held by the ﬁnancial sector.

2

We model the payoﬀ

˜

A

1

, which is risky, as a continuously valued random variable that is realized at t = 1 and

takes values in [0, ∞). The payoﬀ and value of government bonds is discussed below. Finally,

the variable T

0

represents the value of the time 0 transfer made by the government to the

ﬁnancial sector and is discussed further below.

2

While we refer to government claims principally as government bonds, a broader interpretation can

include claims on quasi-governmental agencies (e.g., Fannie Mae, Freddie Mac) and perhaps also the value

of explicit and implicit government guarantees or support.

6

In case of insolvency, debtholders receive ownership of all ﬁnancial sector assets and wage

revenue.

3

Non-ﬁnancial sector: The non-ﬁnancial sector comes into t = 0 with an existing capital

stock K

0

. Its objective is to maximize the sum of the expected values of its net payoﬀs,

which occur at t = 1 and t = 2:

max

s

d

0

, K

1

E

0

_

f(K

0

, s

d

0

) −w

s

s

d

0

+ (1 −θ

0

)

˜

V (K

1

) −(K

1

−K

0

)

_

(2)

The function f is the production function of the non-ﬁnancial sector, which takes as inputs at

t = 0 the ﬁnancial services it demands, s

d

0

, and the capital stock, K

0

, to produce consumption

goods at t = 1. The output of f is deterministic. Moreover, we assume that f is increasing

in both arguments and concave. At t = 1, the non-ﬁnancial sector is faced with a decision of

how much capital K

1

to invest, at an incremental cost of (K

1

−K

0

), in a project

˜

V , whose

payoﬀ is realized at t = 2. This project represents the future or continuation value of the

non-ﬁnancial sector and is in general subject to uncertainty. The expectation at t = 1 of

this payoﬀ is V (K

1

) = E

1

[

˜

V (K

1

)] and, as indicated, is a function of the investment K

1

.

We assume that V

(K

1

) > 0 and V

(K

1

) < 0, so that the expected payoﬀ is increasing but

concave in investment. A proportion θ

0

of the payoﬀ of the continuation project is taxed by

the government to pay its debt, both new and outstanding, as we explain next.

Government: The government’s objective is to maximize the total output of the economy

and hence the welfare of the consumer. It does this by reducing the debt-overhang problem

of the ﬁnancial sector, which induces it to supply more ﬁnancial services, thereby increasing

output. To achieve this, the government issues bonds, that it then transfers to the balance

sheet of the ﬁnancial sector. These bonds are repaid with taxes levied on the non-ﬁnancial

sector at a tax-rate of θ

0

. In particular, the tax rate θ

0

is set by the government at t = 0

and is levied at t = 2 upon realization of the payoﬀ

˜

V (K

1

). We assume that the government

credibly commits to this tax rate.

We let N

D

denote the number of bonds that the government has issued in the past –

its outstanding stock of debt. For simplicity, bonds have a face value of one, so the face

value of outstanding debt equals the number of bonds, N

D

. The government issues N

T

new

3

Note that we could include the wage revenues in the solvency indicator function, which would provide

an additional channel for wages to feed back into the probability of solvency. Although such a channel

would reinforce the mechanism at work in the model, we choose to abstract from this to avoid the additional

complexity.

7

bonds to accomplish the transfer to the ﬁnancial sector. Hence, at t = 2 the government

receives realized taxes equal to θ

0

˜

V (K

1

) and then uses them to pay bondholders N

T

+ N

D

.

We assume that if there are still tax revenues left over (a surplus), the government spends

them on programs for the representative consumer, or equivalently, just rebates them to the

consumer. On the other hand, if tax revenues fall short of N

T

+ N

D

, then the government

defaults on its debt. In that case, it pays out all the tax revenue raised to bondholders. We

assume that the government credibly commits to this payout policy.

4

We further assume that default incurs a deadweight loss. In case of default, the sovereign

incurs a ﬁxed deadweight loss of D. Hence, default is costly and there is an incentive to

avoid it.

5

Finally, let P

0

denotes the price of government bonds, which is determined in

equilibrium. This implies that the value of the ﬁnancial sector’s holding of government

bonds is A

G

= k

A

P

0

N

D

.

The government’s objective is to maximize the expected utility of the representative

consumer, who consumes the combined output of the ﬁnancial and non-ﬁnancial sector.

Hence, the government faces the following problem:

max

θ

0

, N

T

E

0

_

f(K

0

, s

0

) +

˜

V (K

1

) −c(s

0

) −(K

1

−K

0

) −1

def

D +

˜

A

1

_

(3)

where s

0

is the equilibrium provision of ﬁnancial services. This maximization is subject to

the budget constraint: T

0

= P

0

N

T

and subject to the choices made by the ﬁnancial and

non-ﬁnancial sectors. Note that 1

def

is an indicator function that equals 1 if the government

defaults (if θ

0

˜

V (K

1

) < N

T

+N

D

) and 0 otherwise.

Consumer: The representative consumer consumes the output of the economy. He solves a

simple consumption and portfolio choice problem by allocating his wealth W between con-

sumption, government bond holdings, and equity in the ﬁnancial and non-ﬁnancial sectors.

Since the representative consumer is assumed to be risk-neutral, asset prices equal the ex-

pected values of asset payouts. Let P(i) and

˜

P(i) denote the price and payoﬀ of asset i,

respectively. At t = 0, the consumer chooses optimal portfolio allocations, {n

i

}, that solve

4

We can consider more generally a policy whereby the government pays only a fraction ˜ m of tax revenue

and gives back any remaining tax funds to the consumer. Since it will actually be optimal for the government

to commit to paying bondholders all the tax revenue raised, we restrict ourselves to the case ˜ m = 1.

5

Although D here is obviously reduced-form, one can think of the deadweight cost in terms of loss

of government reputation internationally, loss of domestic government credibility, degradation of the legal

system and so forth. If a country’s reputation is already weak, it will have less to lose from default.

8

the following problem:

max

n

i

E

0

_

Σ

i

n

i

˜

P(i) + (W −Σ

i

n

i

P(i))

_

(4)

The consumer’s ﬁrst order condition gives the standard result that equilibrium price of an

asset equals the expected value of its payoﬀ, P(i) = E

0

[

˜

P(i)].

3 Equilibrium Outcomes

We begin by examining the maximization problem of the ﬁnancial sector. Let p(

˜

A) denote

the probability density of

˜

A. Furthermore, let A

1

be the minimum realization of

˜

A

1

for which

the ﬁnancial sector does not default: A

1

= L

1

−A

G

−T

0

. Then, the ﬁrst order condition of

the ﬁnancial sector can be written as:

w

s

p

solv

−c

(s

s

0

) = 0 . (5)

where p

solv

≡

_

∞

A

1

p(

˜

A

1

)d

˜

A, is the probability that the ﬁnancial sector is solvent at t = 1.

We assume that at the optimal ˆ s

s

0

the ﬁrst-order condition is satisﬁed. The second-order

condition of the ﬁnancial sector’s problem is −c

(s

s

0

) < 0. The parametric choice we will use

below for c(s

0

) is c(s

0

) = β

1

m

s

m

0

where m > 1.

Consider now the problem of the non-ﬁnancial sector at t = 0. Its demand for ﬁnancial

services, ˆ s

d

0

, is determined by its ﬁrst-order condition:

∂f(K

0

, s

d

0

)

∂s

d

0

= w

s

. (6)

Since f is concave in its arguments, the second order condition is satisﬁed:

∂

2

f(K

0

,s

d

0

)

∂

2

s

d

0

< 0.

Henceforth, we will parameterize f as Cobb-Douglas with the factor share of ﬁnancial services

given by ϑ: f(K

0

, s

0

) = αK

1−ϑ

0

s

ϑ

0

.

In equilibrium the demand and supply of ﬁnancial services are the same: ˆ s

d

0

= ˆ s

s

0

. From

here on, we drop the superscripts on s

0

and denote the equilibrium quantity of ﬁnancial

services simply by s

0

.

9

3.1 Transfer Reduces Underprovision of Financial Services

Taken together, the ﬁrst-order conditions of the ﬁnancial sector (5) and non-ﬁnancial sector

(6) show how debt-overhang impacts the provision of ﬁnancial services by the ﬁnancial sector.

The marginal beneﬁt of an extra unit of ﬁnancial services to the economy is given by w

s

,

while the marginal cost, c

(s

0

), is less than w

s

if there is a positive probability of insolvency.

This implies that the equilibrium allocation is sub-optimal. The reason is that the possibility

of liquidation p

solv

< 1 drives a wedge between the social and private marginal beneﬁt of an

increase in the provision of ﬁnancial services. The result is that as long as p

solv

< 1, there is

an under-provision of ﬁnancial services relative to the ﬁrst-best case (p

solv

= 1). Hence, we

obtain that

Lemma 1. An increase in the transfer T

0

leads to an increase in the provision of ﬁnancial

services since this raises the probability p

solv

that the ﬁnancial sector is solvent at t = 1.

3.2 Tax Revenues: A Laﬀer Curve

Next, to understand the government’s problem, we ﬁrst look at how expected tax revenue

responds to the tax rate, θ

0

. Let the expected tax revenue, θ

0

V (K

1

), be denoted by T .

Raising taxes has two eﬀects. On the one hand, an increase in the tax rate θ

0

captures a

larger proportion of the future value of the non-ﬁnancial sector, thereby raising tax revenues.

On the other hand, this reduces the incentive of the non-ﬁnancial sector to invest in its future,

thereby leading to reduced investment, K

1

. At the extreme, when θ

0

= 1, the tax distortion

eliminates the incentive for investment and tax revenues are reduced to zero. Hence, tax

revenues are non-monotonic in the tax rate and maximized by a tax rate strictly less than 1.

Formally, the impact on tax revenue of an increase in the tax rate is given by:

∂T

∂θ

0

= V (K

1

) +θ

0

V

(K

1

)

dK

1

dθ

0

Note that at θ

0

= 0, an increase in the tax rate increases the tax revenue at a rate equal to

V (K

1

), the future value of the non-ﬁnancial sector. It can be shown that since the production

function V (K

1

) is concave, as taxes are increased the incentive to invest is decreased by the

tax rate, which reduces the marginal revenue of a tax increase. This is given by the second

term on the right-hand side of the expression. To see this, consider the ﬁrst-order condition

10

for investment of the non-ﬁnancial sector at t = 1:

(1 −θ

0

)V

(K

1

) −1 = 0 (7)

Since V

(K

1

) < 0, the second-order condition holds. Taking the derivative with respect to

θ

0

by using the Implicit Function theorem gives:

dK

1

dθ

0

=

V

(K

1

)

(1 −θ

0

)V

(K

1

)

< 0

which shows that as the tax rate is increased, the non-ﬁnancial sector reduces investment. In

fact, since we know that at θ

0

= 1 the tax revenue is zero, it must be the case that as the tax

rate is increased, the marginal tax revenue decreases until it eventually becomes negative.

To summarize, tax revenues satisfy the Laﬀer curve property as a function of the tax rate:

Lemma 2. The tax revenues, θ

0

V (K

1

), increase in the tax rate, θ

0

, as it increases from zero

(no taxes), and then eventually decline.

Henceforth, we parameterize V with the functional form V (K

1

) = K

γ

1

, 0 < γ < 1.

6

As

Appendix A.3 shows, (7) implies that T = θ

t+1

γ

γ

1−γ

(1−θ

t+1

)

γ

1−γ

. It can then be shown that:

Lemma 3. The tax revenue, T , is maximized at θ

max

0

= 1 −γ, is increasing (dT /dθ

0

> 0)

and concave (d

2

T /dθ

2

0

< 0) on [0, θ

max

0

), and decreasing (dT /dθ

0

< 0) on (θ

max

0

, 1).

3.3 Optimal Transfer Under Certainty and No Default

We analyze next the government’s decision starting ﬁrst with a simpliﬁed version of the

general setup. We make two simplifying assumptions: (1) we set to zero the variance of the

realized future value of the non-ﬁnancial sector, so that

˜

V (K

1

) = V (K

1

), (2) we force the

government to remain solvent. In subsequent sections we remove these assumptions.

If the government must remain solvent, it can only issue a number of bonds N

T

that

it can pay oﬀ in full, given its tax revenue. By assumption (1), the tax revenue is known

exactly (it is equal to T ), and hence by assumption (2), N

T

+ N

D

= T . Moreover, since

every bond has a sure payoﬀ of 1, we know that the bond price is P

0

= 1.

6

This functional form is a natural choice for an increasing and concave function of K

1

. Appendix A.2

provides a more structural motivation for this choice based on the calculation of a continuation value un-

der our choice of production function. This calculation suggests that the continuation value implied by a

multiperiod model should take a similar functional form.

11

Under the two simplifying assumptions, we have that the transfer to the ﬁnancial sector

is T

0

= θ

0

V (K

1

) − N

D

and there is no probability of default, E[1

def

] = 0. Hence, the only

choice variable for the government in this case is the tax rate. Since there is no change in the

non-ﬁnancial sector’s investment opportunities between t = 0 and t = 1, the government’s

information regarding expected tax revenue is the same at t = 0 as at t = 1, and we can

consider the problem directly at t = 0. Appendix A.4 shows that the ﬁrst-order condition

for the government can be written as:

dG

dT

+

dL

dT

= 0 (8)

where

dG

dT

=

∂f(K

0

, s

0

)

∂s

0

(1 −p

solv

)

ds

0

dT

0

dL

dT

=θ

0

V

(K

1

)

dK

1

dT

which expresses the ﬁrst-order condition in terms of the choice of transfer size and expected

tax revenue, rather than in terms of the tax rate. As we explain below, this condition is

intuitive since it equates the marginal gain and marginal loss of increasing tax revenue.

Gain From Increased Provision of Financial Services: The term dG/dT in (8) is

the marginal gain to the economy of increasing expected tax revenue. Equations (5) and

(6) show that it reﬂects the wedge between the social and private beneﬁts of an increase in

ﬁnancial services. Since, as shown above, ds

0

/dT

0

> 0, the marginal gain from increasing tax

revenue (and hence the transfer) will be large when p

solv

is low, that is, when the ﬁnancial

sector is at high risk of insolvency and debt-overhang is signiﬁcant. For illustration, the

graph of dG/dT is given by the solid curve in the top panel of Figure 2.

7

Under-Investment Loss Due to Taxes: The term dL/dT in (8) is the marginal under-

investment loss to the economy due to a marginal increase in expected tax revenue, which

distorts the non-ﬁnancial sector’s incentive to invest. Equation (7) shows that it reﬂects

the size of the tax-induced distortion, which is greater than zero as long as the tax rate is

positive. Since dK

1

/dT < 0, then dL/dT < 0. For illustration, a graph of −dL/dT is shown

as the upward-sloping dashed curve in the top panel of Figure 2.

8

7

As the graph indicates, and as the proof to Proposition 1 shows, G is concave in T since the marginal

gain from increasing tax revenues (to increase the transfer) is decreasing.

8

The curve shows that −L is convex as raising additional tax revenues incurs an increasingly large marginal

12

The Optimal Tax Rate and Issuance of Debt: The following proposition, which de-

scribes the solution to the government’s problem under assumptions 1 (certainty), 2 (no

default) and m ≥ 2ϑ, is proven in Appendix A.6.

Proposition 1. There is a unique optimal tax rate,

ˆ

θ

0

, which is strictly less than θ

max

0

. Let

ˆ

T represent the associated tax revenues. Then newly issued sovereign debt has face value

N

T

=

ˆ

T −N

D

and a price of P

0

= 1. Moreover,

1. The optimal tax rate and revenue are increasing in L

1

, the ﬁnancial sector liabilities,

and in N

D

, the outstanding government debt.

2. The face value of newly issued sovereign debt (the transfer) is increasing in the ﬁ-

nancial sector liabilities L

1

, but decreasing in the amount of existing government debt

N

D

. Moreover, the gross transfer, T

0

+k

A

N

D

, is also decreasing in N

D

.

3. If also m ≤ 2, then the optimal tax rate, revenue, and newly issued sovereign debt, are

increasing in the factor share of the ﬁnancial sector.

The optimal tax rate is less than θ

max

0

due to the Laﬀer-curve property of tax revenues,

whereby the marginal underinvestment loss induced by raising revenue becomes inﬁnite as

the tax rate rises to θ

max

0

. In addition, if there is any debt-overhang (i.e., p

solv

< 1), then

the optimal tax rate will be strictly greater than zero, since at a zero tax rate there is a

marginal beneﬁt to having a transfer but no marginal cost.

The optimal government action is to increase the transfer, by increasing tax revenue and

outstanding debt, until the marginal gain from the transfer no longer exceeds the associated

marginal loss due to underinvestment. For illustration, in the top panel of Figure 2, this

is at the intersection point of the two curves, the x-coordinate of which represents

ˆ

T . The

bottom panel of Figure 2 graphs the value of the government’s objective function, whose

slope is given by (8). As the graph illustrates, the objective is concave in T and the unique

optimum occurs at

ˆ

T , corresponding to the intersection point in the top panel.

Next, consider the three parts of Proposition 1.

For any level of transfer, the marginal gain available is greater the more severe is the

debt-overhang, since a lower probability of solvency increases the distortion in the provision

of ﬁnancial services. This represents an upward shift in the marginal gain curve. Therefore,

underinvestment loss. Furthermore, as shown in Appendix A.5, this marginal loss due to underinvestment

worsens as T is increased, i.e., d

2

L/dT

2

< 0.

13

as (1) and (2) of Proposition 1 state, an increase in L

1

, the ﬁnancial sector liabilities, leads

to a higher tax rate, more tax revenue, and greater issuance of new sovereign debt to fund

a larger transfer.

If the level of pre-existing government debt (N

D

) is increased, there is again an upward

shift in the marginal gain curve, as shown by the dash-dot curve in the top panel of Figure

2. The reason is that for any level of tax revenue, the eﬀective transfer (T

0

) is smaller, and

therefore the probability of solvency is lower. As is clear from the new intersection point in

the top panel, and as (1) of Proposition 1 states, this pushes the government to increase the

optimal tax rate, tax revenue, and overall amount of sovereign debt.

However, as (2) of Proposition 1 shows, the rate of increase in total sovereign debt is less

than the increase in N

D

. Hence, under the no-default and certainty assumptions, an increase

in pre-existing government debt corresponds to a decrease in newly issued sovereign debt

and a smaller transfer T

0

. The reason for this decrease is that the underinvestment cost of

raising additional tax revenues is increasing.

9

Finally, Proposition 1 shows that, ceteris paribus, a larger factor share of the ﬁnancial

sector in aggregate production implies that the government will issue a greater amount of

new debt and a larger transfer. Intuitively, if the ﬁnancial sector’s output is a more important

input into production, then there will be a greater marginal gain from an increase in the

provision of ﬁnancial services due to the transfer.

10

3.4 Default Under Certainty

Now we allow the government to deviate from the no-default choice of setting N

T

= T −N

D

.

Increasing N

T

above this threshold has both an associated cost and beneﬁt. The beneﬁt is

that this can increase the transfer to the ﬁnancial sector. Recall that the transfer T

0

equals

P

0

N

T

, where P

0

= max(1, T /(N

T

+ N

D

)) is the price of the government bond. The cost is

that when N

T

> T −N

D

, the government will not be able to fully cover its obligations. In

that case, P

0

< 1 and the government will default, triggering the dead-weight loss of D.

Hence, the government’s decision on how many new bonds to issue, N

T

, splits the pa-

rameter space into two regions:

1. N

T

= T −N

D

and 1

def

= 0 (No Default)

9

Later, we show that the possibility of default or the introduction of uncertainty can alter this result.

10

The factor share is given by ϑ. Note, however, that the comparative static is not simply to vary ϑ, but

to hold total output constant while doing so. Equivalently, we may think about comparing the ratio to total

output of our variable of interest while varying the factor share.

14

2. N

T

> T −N

D

and 1

def

= 1 (Default)

As shown in Appendix A.7, if the choice to default is made, then it is optimal for the

government to issue an inﬁnite amount of new debt in order to fully dilute existing debt (P

0

becomes 0) and hence capture all tax revenues towards the transfer. The resulting situation

is the same as if pre-existing debt N

D

had been set to zero. Therefore, to determine whether

defaulting is optimal, the government evaluates whether its objective function for given N

D

and no default exceeds by at least D (the deadweight default cost) its objective function

with N

D

set to zero.

Formally, let W

no def

denote the maximum value of the government’s objective function

conditional on no-default, W

def

denote the maximum value conditional on default, and W =

max(W

no def

, W

def

). The following lemma characterizes the optimal government action and

resulting equilibrium:

Lemma 4. Conditional on default, it is optimal to set N

T

→ ∞ (and hence P

0

→ 0).

This implies that W

def

= W

no def

¸

¸

N

D

=0

−D. Moreover, if default is undertaken then (1) the

optimal tax rate is lower,

ˆ

θ

def

0

<

ˆ

θ

no def

0

(2) provided that k

A

N

D

<

ˆ

T

def

, the gross transfer

is bigger,

ˆ

T

0

def

>

ˆ

T

0

no def

+ k

A

N

D

, and (3) equilibrium provision of ﬁnancial services is

higher, ˆ s

0

def

> ˆ s

0

no def

.

Appendix A.7 proves the lemma. We next consider the factors that push the sovereign

towards default.

3.4.1 Default Boundary

Figure 3 displays the optimal default boundary in L

1

×N

D

space along with the No-Default

and Default regions. The following proposition characterizes how a number of factors move

the ‘location’ of the sovereign relative to the default-boundary, or shift the default-boundary

itself.

Proposition 2. Ceteris paribus, the beneﬁt to defaulting is:

1. increasing in the ﬁnancial sector liabilities L

1

(severity of debt-overhang), the amount

of existing government debt N

D

, and in the factor share of the ﬁnancial sector

2. decreasing in the dead-weight default cost D, and in the fraction of existing govern-

ment debt held by the ﬁnancial sector k

A

15

Appendix A.8 provides the proof. Consider a worsening of the ﬁnancial sector’s health,

leading to a decreased provision of ﬁnancial services. This increases the marginal gain from

further government transfer, and, in turn, increases the gain to the sovereign from defaulting.

This is represented by a move towards the right in Figure 3, decreasing the distance to the

default-boundary. A similar kind of result holds if the factor share of ﬁnancial services is

increased, since the marginal gain of further transfer is higher at every level of transfer.

An increase in existing debt implies a bigger spread between the optimal transfer and

optimal tax revenue with and without default. Both the extra transfer and decreased un-

derinvestment represent beneﬁts to defaulting. This is represented by a move upwards in

Figure 3, again decreasing the distance to the default-boundary.

11

It is clear that an increase in the deadweight loss raises the threshold for default. If the

sovereign has a lot to lose from defaulting (think a sovereign with strong domestic credibility

or international reputation) then the net beneﬁt to default will be relatively lower.

Finally, and importantly, an increase in the fraction of existing sovereign debt held by

the ﬁnancial sector also raises the threshold for default since the act of defaulting, which is

aimed at freeing up resources towards the transfer, causes collateral damage to the ﬁnancial

sector balance sheet. From the vantage point of Figure 3, both an increase in D and k cause

an outwards shift in the default boundary.

3.4.2 Two-way Feedback

Propositions 1 and 2 indicate that there is a two-way feedback between the solvency situation

of the ﬁnancial sector and of the sovereign. First, by Proposition 1, a severe deterioration

in the ﬁnancial sector’s probability of solvency (e.g., an increase in L

1

) leads to a large

expansion in new debt (N

T

) by the sovereign, as it acts to mitigate the under-provision of

ﬁnancial services. As the marginal cost of raising the tax revenue (dL/dT ) to fund this debt

expansion is increasing, the sovereign is pushed closer to the decision to default (Proposition

2), as well as is its maximum debt capacity (lemma 3). Hence, a ﬁnancial sector crisis pushes

the sovereign towards distress.

Going in the other direction, by Proposition 1, a distressed sovereign, e.g., one with high

existing debt (N

D

), will have a ﬁnancial sector with a worse solvency situation. This is

because it is very costly for such a sovereign to fund increased debt to make the transfer to

the ﬁnancial sector. Hence, a more distressed sovereign will tend to correspond to a more

11

Moreover, since the marginal loss from funding extra debt is increasing, this beneﬁt is convex in N

D

.

16

distressed ﬁnancial sector (lower post-transfer p

solv

). Strategically defaulting is an avenue for

a distressed sovereign to free debt capacity for additional transfer. However, large holdings

of sovereign debt (k) by the ﬁnancial sector means that taking this avenue simultaneously

causes collateral damage to the balance sheet of the ﬁnancial sector, limiting the beneﬁt

from this option (Proposition 2). In this case, a distressed sovereign is further incapacitated

in its ability to strengthen the solvency of its ﬁnancial sector.

3.5 Uncertainty, Default, and Pricing

We now introduce uncertainty about future output (i.e., growth) by allowing the variance

of

˜

V (K

1

) to be nonzero. Instead of a binary default vs. no-default decision, the government

now implicitly chooses a continuous probability of default when it sets the tax rate and new

debt-issuance. In this case, if raising taxes further incurs a large under-investment loss, the

government can choose to increase debt issuance while holding the tax rate constant. This

dilutes the claim of existing bondholders to tax revenues, thereby generating a larger transfer

without inducing further underinvestment. The trade-oﬀ is an increase in the government’s

probability of default and expected dead-weight default loss. In this case, the sovereign

eﬀectively ‘sacriﬁces’ its own creditworthiness to improve the solvency of the ﬁnancial sector,

leading to a ‘spillover’ of the ﬁnancial sector crisis onto the solvency of the sovereign.

Although θ

0

and N

T

, are the variables the government directly chooses, it will turn out

to be more enlightening to look at two other variables that map to them in a one-to-one

fashion. The ﬁrst variable is T , which again equals θ

0

V (K

1

), the expected tax revenue. The

second variable is:

H =

N

T

+N

D

T

In words, H is the ratio of outstanding debt to expected tax revenue. It measures the

sovereign’s ability to cover its total debt at face value. The government’s problem (3) then

is equivalent to optimally choosing T and H.

12

Note that the no-default and total-default

cases under certainty correspond to setting H = 1 and H →∞, respectively.

To represent uncertainty we write

˜

V (K

1

) = V (K

1

)

˜

R

V

, where

˜

R

V

≥ 0 represents the

shock to

˜

V (K

1

). By construction, E[

˜

R

V

] = 1. We also assume that the distribution of

˜

R

V

12

Formally, the mapping from θ

0

to T is invertible on [0, θ

max

0

] (as before, we can limit our concern to

this region) and given T , the mapping from H to N

T

is invertible. Hence, these alternative control variables

map uniquely to the original ones on the region of interest.

17

is independent of the variables K

1

, θ

0

, and N

T

.

Pricing, Default Probability and the Transfer: Using H we can easily express the

sovereign’s bond price, P

0

, and probability of default, p

def

, as follows:

P

0

= E

0

_

min

_

1,

θ

0

˜

V (K

1

)

N

T

+N

D

__

= E

0

_

min

_

1,

1

H

˜

R

V

__

(9)

p

def

= prob

_

θ

0

˜

V (K

1

) < N

T

+N

D

_

= prob

_

˜

R

V

< H

_

(10)

Note that these quantities depend only on H and do not directly change with T . Next, as

N

T

= (T −N

D

/H)H, we express the transfer in terms of T and H:

T

0

= N

T

P

0

= (T −

N

D

H

)E

0

_

min

_

H,

˜

R

V

__

(11)

The Optimal Probability of Default: Appendix A.9 and A.10 derive the ﬁrst-order

conditions for T and H, respectively. The ﬁrst-order condition for T involves the same

transfer-underinvestment trade-oﬀ as under certainty, adjusted to account for H. Varying H

involves a new trade-oﬀ. As (9)–(11) show, increasing H while holding T constant increases

the transfer, but also increases the probability of sovereign default and decreases the sovereign

bond price. Intuitively, raising H increases the transfer by diluting existing bondholders–it

raises outstanding debt but without increasing expected tax revenue. This captures a greater

faction of tax revenues towards the transfer but raises the probability of default.

The top panel of Figure 4 illustrates the marginal gain (solid line) and loss (dashed line)

incurred by increasing H for a ﬁxed level of T . The dash-dot line represents the marginal

gain curve at a higher level of L

1

than for the solid line. To generate the plots, we need

to assume a speciﬁc distribution for uncertainty. For simplicity, we let

˜

R

V

have a uniform

distribution. As the ﬁgure shows, and as proven in Appendix A.10, the marginal gain curve

is downwards sloping.This is because, as H increases, the marginal increase in the transfer

due to further dilution decreases. The marginal cost of an increase in H is the rise in

expected dead-weight default cost. This is shown by the dashed green line in Figure 4. For

˜

R

V

uniformly distributed, this cost is a ﬂat function of H until the upper end of the support

of the distribution, falling to zero beyond this upper point. Raising H beyond this point

represents sure default (pdef = 1).

Figure 4 indicates that (with T held constant) there are two potential candidates for the

18

optimal choice of H. The ﬁrst is the value of H at which the gain and loss curves intersect.

The second is to let H → ∞, representing a total default and full dilution of existing

bondholders. The bottom panel of Figure 4 plots the corresponding value of the government’s

objective as a function of H. The plot shows that for the conﬁguration displayed, a relatively

small value of H achieves the optimum, which is at the intersection of the gain and loss curves

in the top panel. As this optimal H is beyond the left end of the support of

˜

R

V

(which is

the origin in the ﬁgure), it corresponds to an optimal non-zero probability of default. Note

that beyond the upper end of the support of

˜

R

V

, the objective function again rises in H.

Th reason for this is that, once debt issuance is large enough that default is certain, it is

optimal for the government to fully dilute existing bondholders to obtain the largest possible

transfer.

Finally, the dash-dot curves in Figure 4 correspond to an increase in L

1

(more severe

debt-overhang) relative to the solid lines. As indicated, this worsening of ﬁnancial sector

solvency increases the marginal gain from an increase in H, pushing up the marginal gain

curve in the top panel. In the bottom panel, it pushes down the curve because it lowers

overall welfare. As is apparent in the top panel, the optimal response of the sovereign is

to increase the optimal H (by issuing more debt) in order to increase the transfer. This

comes at the cost to the sovereign of a further increase in the probability of default. From

the bottom panel it is apparent that while total default is still suboptimal, it would become

optimal for a suﬃciently high level of L

1

.

3.5.1 Comparative Statics Under Uncertainty

The government jointly chooses T and H in an optimal way by comparing the relative

marginal cost and beneﬁt of adjusting each quantity. When the marginal beneﬁt of additional

transfer is large, but the marginal underinvestment loss due to taxation is already high, the

government will optimally begin to ‘sacriﬁce’ its own creditworthiness to generate additional

transfer. Therefore, a high L

1

(i.e., a ﬁnancial sector crises) will be associated with both a

high T and a high level of H, up to the point where total default becomes optimal. The

following proposition characterizes how diﬀerent factors impact

ˆ

H and

ˆ

T , the government’s

optimal choices of H and T in equilibrium:

Proposition 3. If (

ˆ

T ,

ˆ

H) is an interior solution to the government’s problem on a region

of the parameter space, then

ˆ

H is increasing in L

1

, in N

D

and in ϑ, and decreasing in

D. Furthermore,

ˆ

T is also increasing in L

1

.

19

To obtain more precise results we choose a speciﬁc distribution for

˜

R

V

. For simplicity,

we again let

˜

R

V

have a uniform distribution. We then plot in Figure 5 comparative statics

of the equilibrium (optimal) values of T , H, T

0

, and P

0

as L

1

and N

D

are varied. The

discontinuities that appears in the plots, as indicated by the dotted lines, represent the

point at which total default becomes optimal.

The top panel of Figure 5 is for L

1

. It shows that T increases monotonically in L

1

,

up to the point where the sovereign chooses total default. The corresponding plot for H

tells a diﬀerent story. For low levels of L

1

, H is held constant at a low value. This value

corresponds to the lower end of the support of

˜

R

V

, so the probability of sovereign default

remains 0. Correspondingly, the plot shows that in this range, P

0

remains fully valued at

1. For suﬃciently high L

1

(e.g., ﬁnancial crisis), the government chooses to increase H. As

discussed above, it ‘sacriﬁces’ its own creditworthiness in order to achieve a larger transfer.

The increase in the transfer is apparent in the subplot for T

0

, while the damage to the

sovereign’s creditworthiness is apparent in the plot for P

0

, which begins to decrease once H

begins to rise.

13

.

The plots also show that, when the ﬁnancial sector’s situation is severe enough (L

1

is

large), the optimal government response can be a total default. The outcome of a total

default is illustrated in the plots at the point of the dotted line. As in the certainty case,

total default fully dilutes existing bondholders, freeing extra capacity for the sovereign to

generate the transfer. As indicated in the plots, this leads to a jump up in T

0

and a jump

down in T . At the same time, P

0

drops to 0.

The bottom panel of Figure 5 shows the comparative statics for N

D

. It is apparent that

for low levels of debt the sovereign keeps H constant at the low end of its support, so there

is no probability of default and P

0

remains at 1. For these values of N

D

, the government

funds the transfer exclusively through increases in tax revenues. Note that in this range the

transfer is decreasing in N

D

, similar to the case of certainty. Once N

D

is suﬃciently high, the

underinvestment costs of increasing tax revenue becomes very high and again the sovereign

begins to increase H to fund the transfer. Consequently, the probability of default rises and

P

0

begins to decrease, as shown in the plot. Interestingly, in this range the combination of

increased H and T imply that the transfer is actually increasing in N

D

. The reason for this

is that for large N

D

, the dilution of existing bondholders is an eﬀective channel for increasing

the transfer. Moreover, as the plots show, at high enough N

D

, total default becomes optimal.

13

Note that the transfer increases more rapidly in L

1

once H begins to increase. This occurs because

higher H means a a greater proportion of expected tax revenue is captured towards the transfer

20

3.6 Government ‘Guarantees’

Government guarantees of ﬁnancial sector debt have been an explicit part of a number of

countries’ ﬁnancial sector bailouts, notably Ireland. Moreover, it has been common for

sovereigns to step in to prevent the liquidation of banks by guaranteeing their debt, which

strongly suggests that there is an implicit ‘safety net’.

14

.

In this section, we add to the model a simple notion of a government guarantee of ﬁnancial

sector debt. We do this for two reasons. First, guarantees are a measure that serves to prevent

liquidation of the ﬁnancial sector by debtholders, which is necessary pre-condition for the

sovereign to act to alleviate debt-overhang and increase the provision of ﬁnancial services.

Second, guarantees are rather unique in that, by construction, their beneﬁt is targeted at

debtholders and not equity holders. This unique feature is important in helping us identify

empirically a main implication of our model, that there is direct feedback between sovereign

and ﬁnancial sector credit risk.

In the interest of simplicity, and since debt-overhang alleviation is the central feature of

bailouts in the model, we do not explore the feedback of the guarantees on the transfer and

taxation decisions analyzed above. Instead, we simply set the stage for the implications of

the guarantees for our empirical strategy.

3.6.1 Avoiding Liquidation

A precursor to the government’s actions to increase the provision of ﬁnancial services is to

prevent liquidation of the ﬁnancial sector. We model debtholders as potentially liquidating

(or inducing a run on) the ﬁnancial sector if they are required to incur losses in case of ﬁ-

nancial sector default. To prevent debtholders from liquidating, the government ‘guarantees’

their debt. That is, it pledges to bondholders

L

1

−

˜

A

1

−T

0

from tax revenues in case of insolvency. This ‘guarantee’ is pari-passu with other claims on

tax revenue. Hence, the ‘guarantee’ has the same credit risk as other claims on the sovereign.

In fact, the ‘guarantee’ is just equivalent to a claim that issues L

1

−

˜

A

1

−T

0

new government

bonds to debtholders in case of insolvency.

Note that this claim accrues exclusively to debtholders and not to equityholders. This

14

The fallout from the failure of Lehman brothers and the apparent desire to prevent a repeat of this

experience has strongly reinforced this view

21

diﬀerentiates it from general assets of the ﬁnancial sector, such as the asset paying

˜

A

1

or

the transfer, T

0

. Importantly, a change in the value of general assets of the ﬁrm changes

the value of equity and debt in a certain proportion, while a change in the value of the

guarantee changes the value of debt but not the value of equity. This implies that, if there

are guarantees, the change in equity value will not be suﬃcient for determining the change

in debt value. The following proposition gives a formal statement of this, derived under a

uniform distribution for

˜

A

1

(same as used above to generate the ﬁgures).

Proposition 4. Let D be the value of debt, E the value of equity, and

˜

A

1

be distributed

uniformly. In the absence of a guarantee, the return on equity is suﬃcient for knowing the

return on debt. In contrast, in the presence of a guarantee, the return on debt is a bivariate

function of both the return on equity and the return on the sovereign bond price.

This bivariate dependence is approximated by the following relation, which is derived in

the Appendix,

d D

D

≈

(1 −p

solv

)(1 −P

0

)

p

solv

E

D

dE

E

+

(1 −p

solv

)

2

2

L

1

P

0

D

dP

0

P

0

(12)

The term involving the equity return captures the impact on the debt value of any changes

in the value of the general pool of assets of the ﬁrm, including expected future proﬁts of

the ﬁrm. This corresponds to the canonical model of debt, following Merton (1974), where

changes in the total value of the ﬁrm are reﬂected in both debt and equity values. In the

presence of a guarantee, there is the additional second component, which picks up the change

in the value of debt coming from changes in the value of the government guarantee. The

change in value of the guarantee, which reﬂects variation in the credit risk of the sovereign,

is concentrated primarily with debt. It is therefore not captured adequately by the return

on equity and requires the second term.

15

3.6.2 Two-way Feedback

As illustrated by Proposition 3 and the discussion of Figure 5, a severe ﬁnancial sector crisis

‘spills over’ onto the sovereign via an increase in H and deterioration of the sovereign’s

15

Note that there is theoretically also an indirect feedback of sovereign credit risk on ﬁnancial sector credit

risk. This is because the guarantee represents additional (state-contingent) debt issuance by the sovereign,

which raises expected default costs of the sovereign and potentially reduces the size of the transfer to the

ﬁnancial sector. As mentioned above, to maintain simplicity we will not incorporate the impact of the

guarantee on the government’s optimal choice of tax revenue or debt issuance. Instead, we will mainly use

the above result to motivate some of our empirical work.

22

creditworthiness. With the introduction of uncertainty about realized tax revenues, the

increase in H varies continuously with the severity of the ﬁnancial sector crisis (L

1

) and

is reﬂected continuously in the price of the sovereign’s bonds (equivalently, in CDS levels).

Moreover, as we have shown, there is an upper value where total default becomes optimal.

In addition, as the bottom panel of Figure 5 shows, higher pre-existing sovereign debt is

associated with lower post-transfer sovereign bond prices.

Going in the other direction, higher pre-existing debt corresponds to a smaller transfer

and therefore, ceteris paribus, a weaker post-transfer ﬁnancial sector (lower post-transfer

p

solv

). Moreover, if the ﬁnancial sector has substantial holdings of existing sovereign bonds

(substantial k

A

), then any resulting decrease in the sovereign’s bond price due to increasing

H causes collateral damage to the ﬁnancial sector’s balance sheet. This decreases the net

transfer to the ﬁnancial sector, leaving it less well-oﬀ post transfer. There is, furthermore,

an additional important consequence of increased H that can be seen from the model with

uncertainty. Once H is increased, not only does the probability of default increase, but so

does the sensitivity of the bond’s ﬁnal payoﬀ to realized growth (and hence tax revenue)

shocks. Since the ﬁnancial sector’s solvency post-transfer is dependent on this payoﬀ due to

its holdings of transfer and pre-existing government bonds, the increase in H will make the ﬁ-

nancial sector more sensitive to shocks to

˜

R

V

(e.g., growth). This implies that, post-transfer,

there will be increased co-movement between the likelihood of sovereign and ﬁnancial sector

solvency.

4 Empirics

In this section we present empirical evidence in favor of the main arguments made by this

paper: (1) the bailouts reduced ﬁnancial sector credit risk but were a key factor in triggering

the rise in sovereign credit risk of the developed countries and (2) there is a two-way feedback

between the creditworthiness of the sovereign and the ﬁnancial sector.

The setting for our empirical analysis is the ﬁnancial crisis of 2007-10. We divide the crisis

into three separate periods relative to the bailouts: pre, around, and after. The pre-bailout

period, which culminated in Lehman Brother’s bankruptcy, saw a severe deterioration in

banks’ balance sheets, a substantial rise in the credit risk of ﬁnancial ﬁrms, and a signiﬁcant

loss in the market value of their equity. This negative shock generated substantial debt

overhang in the ﬁnancial sector and signiﬁcantly increased the likelihood of failure of, or

runs on, ﬁnancial institutions. We interpret this as setting the stage for the initial time

23

period in the model, and the bank bailouts as the sovereign’s response, per the model.

We present our empirical results in two parts. The ﬁrst part focuses on point (1). We

presents evidence that the bailouts transmitted risk from the banks to the sovereigns and

triggered a rise in sovereign credit risk across a broad cross-section of developed countries.

We then conﬁrm a prediction of the model by documenting the emergence post-bailout

of a positive relationship between sovereign credit risk and government debt-to-gdp ratios.

We also analyze the ability of the pre-bailout credit risk of the ﬁnancial sector and pre-

bailout government debt-to-gdp ratio to predict post-bailout credit risk. This relationship

is predicted by the model and is supportive of argument that the bailouts induced increases

in sovereign credit risk.

The second part of our analysis focuses on point (2) by testing for the sovereign-bank

two-way feedback. We make extensive use of a broad panel of bank and sovereign CDS data

to carry out tests that establish this channel and show that it is quantitatively important.

A signiﬁcant challenge in demonstrating direct sovereign-bank feedback is the concern that

another (unobserved) factor directly aﬀects both bank and sovereign credit risk, giving rise

to co-movement between them even in the absence of any direct feedback. We address these

concerns by utilizing a particularly useful feature of government ‘guarantees’–that they are

targeted speciﬁcally at bank debt holders–to control for changes in bank fundamentals.

We also gather and exploit data on the sovereign bond holdings of European banks that

was released after the stress tests conducted in the ﬁrst half of 2010. Using this data we show

that banks’ holdings of foreign sovereign bonds has information about how foreign sovereign

credit risk aﬀects a bank’s credit risk.

We next describe the data construction and provide some summary statistics. This is

followed by the two sections of detailed results and the evidence based on the European bank

stress test data.

4.1 Data and Summary Statistics

We use Bankscope to identify all banks headquartered in Western Europe, the United States,

and Australia with more than $50 billion in assets as of the end of ﬁscal year 2006. We choose

this sample because smaller banks and banks outside these countries usually do not have

traded CDS. We then search for CDS prices in the database Datastream. We ﬁnd CDS

prices for 99 banks and match CDS prices to bank characteristics from Bankscope. Next,

we search for investment grade credit ratings using S&P Ratings Express. We ﬁnd credit

24

ratings for 86 banks and match these data to CDS prices and bank characteristics. Finally,

we match these data to sovereign CDS of bank headquarters and OECD Economic data on

public debt.

Panel A of Table 1 presents summary statistics for all banks with CDS prices and invest-

ment grade credit ratings. As of July 2007, the average bank had assets of $589.3 billion

and equity of $26.8 billion. The average equity ratio was 5.1% and the average Tier 1 ratio

was 8.5%. The average bank CDS was 21.8 basis points and the average sovereign CDS (if

available as of July 2007) was 6.6 basis points.

Panel B of Table 1 present summary statistics of weekly changes in bank CDS and

sovereign CDS for the main bailout periods. We drop all observations with zero changes

in bank CDS or sovereign CDS to avoid stale data. All results presented below are robust

to including these observations. Before the bank bailouts, the average bank CDS was 98.2

basis points. This level of bank credit risk reﬂected primarily banks’ exposure to subprime

mortgages and related assets. The average sovereign CDS was 12.1 basis points. This low

level of sovereign credit risk suggests that ﬁnancial market participants did not anticipate

large-scale bank bailouts prior to September 2008.

In the bailout period, we see a signiﬁcant rise in both bank and credit risk with average

bank and sovereign CDS of 301.3 and 33.6 basis points, respectively. As we discuss below, the

increase in bank credit risk was triggered by the Lehman bankruptcy. After Lehman, most

governments announced bank bailouts aimed at reducing bank credit risk. As a result of

the bailouts, some of the ﬁnancial sector risk was transferred to sovereigns, which increased

average sovereign credit risk. We note that bank equity values declined sharply during this

period with a negative weekly return of 7.4%.

In the post-bailout period, average bank and sovereign CDS were 194.1 and 90.8 basis

points, respectively. These CDS levels are suggestive of a signiﬁcant transfer of ﬁnancial

sector credit risk on sovereign balance sheets. We also ﬁnd signiﬁcant variation in sovereign

CDS with a standard deviation of weekly changes of 12.9%. This evidence suggests the

emergence of signiﬁcant sovereign credit risk after the bank bailouts.

4.2 The Sovereign Risk Trigger

The ﬁrst bank bailout announcement in Western Europe was on September 30, 2008 in

Ireland. Therefore we deﬁne the pre-bailout period as ending on September 29, 2008. We

start it in March 2007, prior to the start of the ﬁnancial crisis. Note that this period

25

includes the bankruptcy of Lehman Brothers on September 15, 2008, but also the period

immediately afterwards, so that it includes the immediate eﬀect of Lehman’s bankruptcy on

other banks prior to the Ireland announcement. Hence, the pre-bailout period captures both

the prolonged increase in bank credit risk during 2007-2008 and the post-Lehman spike that

occurs before the bank bailouts.

We compute the change in sovereign CDS and bank CDS during this period for all

countries in our data set. For each country we compute the change in bank CDS as the

unweighted average of all the banks with CDS prices. We omit countries for which either

sovereign CDS or banks CDS are not available. Figure 6 summarizes the results for the

pre-bailout period. For each country, the ﬁrst column depicts the change in sovereign CDS

and the second column depicts the change in bank CDS over the pre-bailout period. The

ﬁgure shows that there is a large increase in banks CDS prior to the bank bailouts. For

example, the average bank CDS in Ireland increases by 300 basis points over this period.

However, there is almost no change in sovereign CDS. Overall, the ﬁgure shows that the

credit risk of the ﬁnancial sector was greatly increased over the pre-bailout period but that

there was little impact on sovereign credit risk.

We note that some investors may have expected bank bailouts even before the ﬁrst oﬃcial

announcement on September 30, 2008. Such an expectation would reduce the observed

increase in bank CDS and shift forward in time the rise in sovereign CDS. To the extent that

investors held such expectations prior to September 30, 2008, they can explain the small

rise in sovereign CDS that occurs late in the pre-bailout period. However, the fact that the

impact in this period is so small quantitatively suggest that the bank bailouts were a surprise

to the majority of investors.

Almost every Western European country announced a bank support program in October

2008. Most bank support programs consisted of asset purchase programs, debt guarantees,

and equity injections or some combination therefore. Several countries made more than

one announcement during this period. As noted above, the ﬁrst country to make a formal

announcement was Ireland on September 30, 2010. Many other countries soon followed

Ireland’s example, in part to oﬀset outﬂows from their own ﬁnancial sectors to newly secured

ﬁnancial sectors. As a result, the bank bailout announcements were not truly independent

since sovereigns partly reacted to other sovereigns’ announcements. We therefore deﬁne the

around-bailouts period as the period in which the bank bailout announcements occurred.

Figure 7 plots the average change in bank CDS and sovereign CDS over the bailouts

period. As shown in the ﬁgure, bank CDS signiﬁcantly decreased over this one-month period.

26

For example, the average bank CDS in Ireland decreased by about 200 basis points. Similarly,

most other countries had a signiﬁcant decrease in bank CDS, especially ones that had a

large increase over the pre-bailout period. At the same time, there is a signiﬁcant increase in

sovereign CDS. For example, the sovereign CDS of Ireland increased by about 50 basis points.

Most other countries exhibit a similar pattern with decreasing bank CDS and increasing

sovereign CDS.

The appearance of this striking pattern across a broad cross-section of countries is di-

rectly in line with the predictions of our model. It shows that the sovereigns responded to

the distress in the ﬁnancial sector with the bailouts, achieving a substantial reduction in

banks’ credit risk. However, in accordance with our model, this caused a contemporaneous,

immediate increase in the sovereigns’ credit risk. Indeed the ﬁgures clearly show that these

sharp increases were aligned tightly with the bailout announcement period.

We deﬁne the post-bailout period as beginning after the end of the bank bailouts and

ending in March 2010. We choose March 2010 because this is the date for which the European

bank stress data results were released. The results are robust to using other cut-oﬀ dates in

2010. Figure 8 plots the change in bank CDS and sovereign CDS over this post-bailout period.

It shows that both sovereign CDS and bank CDS increased across all countries. Moreover,

it is clear that bank CDS and sovereign CDS move together after the bank bailouts. This

suggests that they are tied together and feedback on each other as our model suggests.

Our model predicts that the bailouts should lead to an increase in sovereign credit risk

and that the post-bailout level of credit risk should depend on pre-bailout debt and the

pre-bailout level of ﬁnancial sector distress. Moreover, the model suggests that there should

emerge after the bailouts a positive relationship between measures of government debt-to-gdp

even if such relationship appears before.

We test these predictions using data on sovereign CDS, ﬁnancial sector distress, and gov-

ernment debt-to-gdp ratios. We measure pre-bailout ﬁnancial sector distress at the country

level by averaging bank CDS on September 22, 2008. We choose this date midway between

Lehman’s bankruptcy and the ﬁrst bailout announcement. We measure the government

debt-to-gdp ratio as the government gross liabilities as a percentage of gdp. For the post-

bailout date we choose March 31, 2010, the reporting date for the European bank stress

tests.

Table 2 presents the result of our analysis. Column (3) shows the result from regress-

ing post-bailout log sovereign CDS on post-bailout debt-to-gdp. There is a clear, positive

27

relationship and the coeﬃcient is statistically signiﬁcant.

16

This relationship is shown in

the bottom panel of Figure 9. Column (4) shows the result when the log of the pre-bailout

ﬁnancial distress variable is also added as a dependent variable. As Column (4) shows the

coeﬃcient on pre-bailout ﬁnancial distress is large and highly statistically signiﬁcant. The

coeﬃcient shows that a 1% increase in pre-bailout ﬁnancial sector distress increases post-

bailout sovereign CDS by 0.965%. The coeﬃcient on debt-to-gdp decreases slightly but

remains marginally signiﬁcant. The R-squared of the regression is close to 50%.

In contrast, Column (1) of Table 2 shows that in the pre-bailout period there is only

a very weak relationship between debt-to-gdp and sovereign CDS. The coeﬃcient is small

and is statistically insigniﬁcant. This is displayed in the upper panel of Figure 9. Column

(3) shows that the coeﬃcient on ﬁnancial sector distress in the pre-bailout period is also

statistically insigniﬁcant.

From these results we can see that there emerged a relationship between debt-to-gdp and

sovereign credit risk that was not present beforehand. Note, moreover, that the emergence

of this relationship coincides with an overall rise in sovereign debt ratios. From the point of

model, the sovereigns have increased debt-ratios into the region where dilution occurs and

there is a negative relationship between debt-ratio and price (see Figure 5).

Columns (5) examines the ability of pre-bailout ﬁnancial sector distress to predict the

change in government debt-to-gdp from the pre-bailout to the post-bailout period. Consis-

tent with the model, we ﬁnd that ﬁnancial sector distress is positively related to the increase

in debt-to-gdp. The coeﬃcient is positive and marginally statistically signiﬁcant. Column (6)

shows that consistent with the model’s predictions, post-bailout debt-to-gdp is predicted by

pre-bailout debt-to-gdp and pre-bailout ﬁnancial sector distress. Both coeﬃcients are statis-

tically signiﬁcant and together the two variables explain 84% of the variation in post-bailout

debt-to-gdp.

4.3 The Sovereign-Bank Feedback

In this section we analyze the two-way feedback between sovereign and bank sector credit

risk. Once the sovereign opens itself up to credit risk due to bailouts, the price of its debt

16

We make note of two points. First, the model predicts that H determines the level of sovereign CDS.

However, the debt-to-gdp ratio corresponds to θ

0

H in the model rather than simply H. Nevertheless, the

prediction of the model carries over to θ

0

H since θ

0

is increasing in ﬁnancial sector distress. Second, debt-

to-gdp ratios are an imperfect proxy for θ

0

H because H takes into account any future issuance of debt to

pay for current obligations related to the bailouts, whereas debt-to-gdp ratios are lagging. We can address

this to some extent by using leading debt-to-gdp.

28

becomes sensitive to macroeconomic shocks. This leads a second direction of feedback, from

the sovereign to the ﬁnancial sector. Our model indicates that subsequent changes in the

sovereign’s credit risk should impact the ﬁnancial sector’s credit risk through three channels:

(i) ongoing bailout payments and subsidies,

17

(ii) direct holdings of government debt, (iii)

explicit and implicit government guarantees.

The feedback channels imply that we should ﬁnd that changes in sovereign and bank

credit risk are positively correlated. We start by estimating the following relationship in the

post-bailout period:

∆log(Bank CDS

ijt

) = α +β∆log(Sovereign CDS

jt

) +ε

ijt

where ∆log(Bank CDS

ijt

) is the change in the log CDS of bank i headquartered in country

j from time t to time t − 1 and ∆log(Sovereign CDS

jt

) is the change in the log Sovereign

CDS of country j from time t to time t − 1. At the weekly frequency, the estimate of β is

0.47 and is highly statistically signﬁcant. This means that a 10% increase in sovereign CDS

is associated with a 4.7% increase in bank CDS. This result shows that sovereign and bank

CDS exhibit a strong comovement and is consistent with direct sovereign-bank feedback.

However, an obvious concern is that there is another (unobserved) factor that aﬀects

both bank and sovereign credit risk. Such a factor would explain their co-movement without

there necessarily being an underlying direct channel between them. More speciﬁcally, we

interpret changes in sovereign credit risk as changes in expectations about macroeconomic

fundamentals, such as employment, growth, and productivity. These fundamentals also have

a direct eﬀect on the value of bank assets such as mortgages or bank loans. Hence, changes

in macroeconomic conditions may generate a correlation between sovereign and bank credit

risk even in the absence of direct feedback. Therefore, establishing that there is indeed direct

feedback between sovereign and ﬁnancial sector credit risk is a signiﬁcant challenge.

We take a number of steps to address this concern. In the ﬁrst step, we add controls

that capture market-wide changes that aﬀect both bank and sovereign risk directly. Our

market-wide controls are a CDS-market index and a measure of aggregate volatility. Our

CDS market index is the iTraxx Europe index, which is comprised of 125 of the most liquid

17

While we model the bailout as happening in one stage, in practice bailouts may occur in mutliple steps.

This may occur when early eﬀorts are deemed to be insuﬃcient. As with the one-stage bailout in our model,

the sovereign’s creditworthiness is important in determining the potential for and magnitude of future bailout

steps. This presents another, dynamic channel through which changes in sovereign creditworthiness impact

both ﬁnancial sector debt and equity values.

29

CDS names referencing European investment grade credits. The CDS market index captures

market-wide variation in CDS rates caused by changes in fundamental credit-risk, liquidity,

and CDS-market speciﬁc shocks.

18

For the volatility index we follow the empirical literature

and use a VIX-like index, the VDAX, which is the DAX-counterpart to the VIX index for

the S&P 500. This captures changes in aggregate volatility which is an important factor in

the pricing of credit risk. In the second step, we include weekly ﬁxed eﬀects. For each week,

the ﬁxed eﬀect captures any variation that is common across all banks. In the third step,

we include bank-speciﬁc coeﬃcients on all the control variables and bank ﬁxed eﬀects. This

accommodates potential non-linearities in relationships.

We implement this approach by estimating the following regression:

∆log(Bank CDS

ijt

) = α

i

+δ

t

+β∆log(Sovereign CDS

jt

) +γ∆X

ijt

+ε

ijt

where ∆X

ijt

are the changes in the control variables from time t to time t − 1, δ

t

are the

weekly ﬁxed eﬀects, and the α

i

are bank ﬁxed-eﬀects

Table 3 shows the results for the pre, around, and post-bailout periods. For each period

there are three columns of results. The left column reports the coeﬃcient estimates including

the market-wide control variables. The middle column adds the weekly ﬁxed eﬀects. The

right column adds the bank-speciﬁc coeﬃcients on the controls and bank ﬁxed eﬀects.

Our main focus is on testing for the sovereign-bank feedback, so we examine the post-

bailout results ﬁrst. Column (7) shows that β is positive, as expected, and highly statistically

signiﬁcant. The magnitude is also economically important, implying that an independent

increase in sovereign CDS of 10% translates into a 1.63% increase in bank CDS. The control

coeﬃcients are both statistically signiﬁcant and the signs are as expected; an increase in

aggregate CDS levels or volatility is associated with a rise in banks’ CDS. As would be

expected, the coeﬃcient on CDS market is large. Altogether, the variables explain 31.6% of

the variation in weekly bank CDS.

Column (8) adds the weekly ﬁxed eﬀects. The coeﬃcient on sovereign CDS decreases but

remains highly statistically signiﬁcant. The decrease is not surprising, as time ﬁxed eﬀects

represent a very rich set of controls. Note that the weekly ﬁxed eﬀects are collinear with the

market-wide control variables. Therefore, we do not estimate coeﬃcients on the market-wide

18

Collin-Dufresne, Goldstein, and Martin (2001) ﬁnd that a substantial part of the variation in corporate

credit spread changes is driven by a single factor that is independent of changes in risk factors or measures

of liquidity. They therefore conclude that this variation represents ‘local supply/demand shocks’ in the

corporate bond market.

30

controls. There is an increase in the R-squared ofabout 7% over column (7), indicating that

most of the variation was already captured by the market-wide controls.

Column (9) shows that the coeﬃcient on sovereign CDS is essentially unchanged and

remains highly statistically signiﬁcant after adding bank-speciﬁc coeﬃcients on the control

variables . Given the ﬂexibility of this speciﬁcation we interpret the survival of the coeﬃcient

on sovereign CDS as robust evidence in favor of direct sovereign-bank feedback.

Comparing these results with those for the around-bailout period in columns (4)-(6)

shows interesting diﬀerences. For the around-bailout period, the coeﬃcient on sovereign

CDS is negative. In other words, in the around-bailout period an independent increase in

sovereign CDS is associated with a decrease in bank CDS. This is very much consistent with

the evidence presented above that the sovereigns took onto themselves credit risk from their

ﬁnancial sectors during this phase. More precisely, it is evidence that in fact sovereigns that

took on more credit risk, and hence saw a greater increase in their CDS, decreased by a

greater amount their banks’ CDS. Perhaps due to the short time-series, the coeﬃcients are

only marginally signiﬁcant. When the panel is estimated at the daily frequency they do in

fact come up signiﬁcant (unreported).

Columns (1)-(3) show the results for the pre-bailout period. They show a small coeﬃcient

on sovereign CDS that is indistinguishable from 0. Hence, in the pre-bailout period there is

no evidence for sovereign-bank feedback. In contrast, the CDS market control coeﬃcient is

signiﬁcant and has a large magnitude, similar to the results for the other periods.

4.3.1 Controlling for Bank Fundamentals

The results above establish that there is a strong sovereign-bank feedback. However, there

may remain a concern that our strategy to this point does not control for country-speciﬁc

macroeconomic shocks that bank-level fundamentals. For example, a negative macroeco-

nomic shock will decrease the value of banks’ assets or future earnings power, while at the

same time reducing national output. This will raise bank and sovereign CDS even in the

absence of a direct feedback between them. This shock may not be fully captured by our

market-wide controls if it has a heterogenous impact across countries.

We address this concern using a strategy that utilizes a particularly useful feature of

government ‘guarantees’–they are targeted speciﬁcally at bank debt holders. This implies

that sovereign-speciﬁc shocks should have a disproportionate impact on debt holders because,

in addition to changing the value of bank assets, such shocks change the value of government

‘guarantees’ (implicit or explicit). Therefore, to establish whether there is a direct channel

31

we can test if sovereign CDS is still a determinant of bank CDS after we control for the

impact of shocks to bank fundamentals.

Our strategy for dealing with this concern is motivated by the model. Proposition 4 shows

that bank equity returns are suﬃcient for determining changes in bank CDS in the absence

of government ‘guarantees’.

19

This implies that once we control for bank equity returns

we should not ﬁnd that changes in sovereign CDS have any further explanatory power for

changes in bank CDS. Indeed, a-priori it seems that even if there are direct sovereign-to-

bank channels, their impact may be subsumed into an equity control, making it diﬃcult

to document their existence. On the other hand, if one ﬁnds that sovereign CDS does

have further explanatory power beyond equity returns, then this is strongly supportive of a

sovereign-to-bank feedback channel. Proposition 4 shows that ‘guarantees’ present a source

for such a potential ﬁnding because they discriminate precisely in favor of debtholders. In

the presence of ‘guarantees’, a regression that controls for equity returns should still ﬁnd a

(negative) beta on changes in sovereign CDS.

We therefore augment the regression with banks’ weekly equity returns. The estimates

are shown in Table 4. The structure is similar to Table 3. Columns (7)-(9) show that

in the post-bailout period we ﬁnd that the coeﬃcient on sovereign CDS survives and is

highly statistically signiﬁcant. As shown in columns (7) and (8), although the bank stock

return coeﬃcient is highly statistically signiﬁcant and possesses the expected negative sign,

its inclusion has little impact on the magnitude of the sovereign CDS coeﬃcient. Column

(9) includes bank-speciﬁc coeﬃcients on bank stock returns. The results show that the

coeﬃcient on sovereign CDS decreases somewhat but remains highly signiﬁcant.

For the bailout and pre-bailout periods, the results are quite similar to those in Table 3.

As shown in columns (1) to (6), we again ﬁnd a negative coeﬃcient on sovereign CDS in the

bailout period and an essentially zero coeﬃcient in the pre-bailout period.

4.3.2 Bank-level Heterogeneity

To analyze further sovereign-bank feedback we also examine whether heterogeneity in bank

characteristics aﬀects banks’ sensitivity to changes in sovereign CDS. To this end, we estimate

the coeﬃcient on an interaction term of changes in sovereign CDS and a bank’s Tier 1 capital

ratio. The Tier 1 capital ratio is commonly used in the banking industry as a proxy for a

19

This result is in fact quite general. It holds in models of defaultable bond pricing that build on the

canonical model of Merton (1974), where stock returns contain all information about changes in bank asset

values and therefore can (locally) capture all variation in the price of debt.

32

bank’s probability of solvency. This speciﬁcation is motivated by the model. Equation (12)

suggests that we should ﬁnd that the magnitude of the coeﬃcient on changes in sovereign

CDS is decreasing in banks’ Tier 1 ratios. Intuitively, the impact of changes in the value of

government guarantees stronger for less well-capitalized banks.

Table 5 reports the results. The coeﬃcient of interest is the interaction term. For the

post-bailout period, the negative estimates for the interaction term indicate that banks with

higher Tier 1 ratios were less sensitive to variation in sovereign CDS rates. Although the

estimates are negative in columns (7) to (9), only column (9), which includes the full set of

controls is statistically signiﬁcant.

The results in the bailout period are surprising. Similar to the post-bailout period, the

coeﬃcient on the interaction term is negative. However, this implies that well-capitalized

banks experienced a larger CDS decrease relative to poorly capitalized banks during the

bailout period. In the pre-bailout period, the interaction term is positive but small and

statistically insigniﬁcant.

4.3.3 The Impact on Equity Value

For the purposes of establishing the existence of a two-way feedback we have mainly focused

on changes in bank CDS. It is also interesting to look at the impact of bailouts on bank

stock returns. From the viewpoint of the model, bank stock returns should reﬂect changes

in sovereign credit risk due to their impact on the value of continuing bailout payments and

banks’ holdings of government bonds. To that end, we estimate the following regression:

Bank Stock Return

ijt

= α

i

+δ

t

+β∆log(Sovereign CDS

jt

) +γ∆X

ijt

+ε

ijt

where Bank Stock Return

ijt

is the stock return of bank i headquartered in country j from

time t to time t −1. We use the same control variables as in Table 4.

Table 6 presents the results. Columns (7) to (9) show that in the post-bailout period an

increase in sovereign CDS is associated with a decrease in bank stock returns. This result

is robust to the inclusion of the full set of controls. Note also that the coeﬃcients on the

controls have the expected signs and are signiﬁcant.

Perhaps somewhat surprisingly, the coeﬃcient on sovereign CDS is not distinguishable

from zero during the bailout period. The point estimate is positive in columns (5) and (6),

but is not statistically signiﬁcant. Still, across the board, the point estimates are clearly

higher than for the post-bailout period, which is consistent with the idea that equity holders

33

beneﬁtted from bank bailouts. One potential oﬀsetting eﬀect on this result is that in some

countries the beneﬁts of bailouts to equity holders were oﬀset by charges (or expectations of

charges) levied by the government. Columns (1) to (3) show that as before, the coeﬃcient

on sovereign CDS in the pre-bailout period is essentially zero.

4.4 European Bank Stress Test Analysis

As a ﬁnal part of our analysis, we use data on the sovereign bond holdings of European

banks. These data were released as part of the European bank stress tests, which were

conducted in the ﬁrst half of 2010. The data provide a view of a bank’s bond holdings of

both its own government bonds and those of other European countries.

We ﬁrst describe the data and provide summary statistics. We collect the stress test

data from the websites of national bank regulators in Europe. The data consists of bank

characteristics and holdings of European sovereign bonds. A total of 91 banks participated

in the bank stress tests. These banks represent about 70 percent of bank assets in Europe.

For all banks, we search for CDS prices in the database Datastream. Using bank names,

we match 51 banks to CDS prices. Unmatched banks are mostly smaller banks from Spain

and Eastern Europe that do not have publicly quoted CDS prices. For each bank we match

sovereign holdings to sovereign CDS and compute a measure of exposure to sovereign credit

risk.

Table 7 presents summary statistics for all banks that participated in the European bank

stress tests. As of March 2010, the average bank had risk-weighted assets of 126 billion

euros and a Tier 1 capital ratio of 10.2%. The average holdings of gross and net European

sovereign bonds are 20.6 billion euros and 19.7 billion euros, respectively. Hence, the average

bank holds about one sixth of risk-weighted assets in sovereign bonds. Banks have a strong

home bias in their sovereign holdings: about 69.4% of bonds are issued by the country in

which a bank is headquartered. This is supportive of the model’s assumption that banks are

exposed to home-country sovereign risk through their holdings of government bonds.

We use these data to conduct an alternative test of the impact of sovereign credit risk

on bank credit risk. Our test focuses uses information on changes in the value of foreign-

sovereign holdings rather than own-country sovereign holdings. The beneﬁt of this approach

is that it circumvents the usual concerns about omitted country-speciﬁc macro shocks.

To implement this test, we construct a bank-speciﬁc variable measuring variation in

the value of banks’ foreign sovereign bond holdings. Let SovBond

ik

be the share of for-

34

eign sovereign holdings of country k by bank i. We calculate the foreign holdings variable,

ForeignBondCDS

it

as the following weighted average:

ForeignBondCDS

it

=

i=j

SovBond

ik

∗ SovereignCDS

kt

.

where SovereignCDS

kt

is the sovereign CDS of country k on day t. Note that for each bank

the foreign holdings variable excludes home-sovereign bonds. We then estimate the following:

∆log(Bank CDS

it

) = δ

t

+γ∆log(ForeignBondCDS

it

) +ε

it

. (13)

where δ

t

are time ﬁxed eﬀects. The coeﬃcient of interest is γ, which captures the eﬀect of

changes in the value of foreign bond holdings on the bank’s CDS.

We estimate the regressions using the period one month before and one month after

the reporting date for the sovereign bond holdings. By estimating this regression, we are

implicitly assuming that the marginal CDS investor either knows or at least has some idea

of the bank holdings.

Table 8 shows the results. Column (1) shows a positive and statistically signiﬁcant asso-

ciation between changes in banks’ CDS and their foreign sovereign holdings. This coeﬃcient

suggests that a one-standard deviation increase in the change in the foreign sovereign hold-

ings variable leads to an increase of about half of a one-standard deviation in the change of

the bank CDS. Column (2) shows that the coeﬃcient remains unchanged when bank ﬁxed

eﬀects are included. Column (3) controls for week ﬁxed eﬀects. The coeﬃcient of interest

decreases from 0.325 to 0.261. This suggests that common shocks aﬀect both the change

in bank CDS and the change in the foreign holdings variable. Column (4) controls for day

ﬁxed eﬀects. In this case, the coeﬃcient is identiﬁed only oﬀ the cross-sectional variation in

the value of foreign sovereign holdings. The coeﬃcient decreases to 0.141 but remains sta-

tistically signiﬁcant at the 1%-level. This result suggests that variation in foreign sovereign

holdings contains economically important information about variation in bank credit risk.

To further check for robustness, column (5) adds back bank ﬁxed eﬀects. This does

not have any eﬀect on the coeﬃcient. Column (6) estimates the same regression as in

Column (5) but excludes the holdings of German bonds from the construction of the foreign-

holdings variable. We do this to address a potential concern about reverse causality due

to the possibility that Germany may provide bailouts to other countries, or banks in other

countries. The column shows that this has no eﬀect on the coeﬃcient of interest.

35

5 Related literature

Our paper is related to three diﬀerent strands of literature: (i) the theoretical literature on

bank bailouts; (ii) the literature on costs of sovereign default; and, (iii) the recent empirical

literature on eﬀects of bank bailouts on sovereigns.

The theoretical literature on bank bailouts has mainly focused on how to structure bank

bailouts eﬃciently. While the question of how necessarily involves an optimization with

some frictions, the usual friction assumed is the inability to resolve failed bank’s distress

entirely due to agency problems. This could be due to under-investment problem as in our

setup (e.g., Philippon and Schnabl, 2009), adverse selection (e.g., Gorton and Huang, 2004),

risk-shifting or asset substitution (e.g., Acharya, Shin and Yorulmazer, 2008, Diamond and

Rajan, 2009), or tradeoﬀ between illiquidity and insolvency problems (e.g., Diamond and

Rajan, 2005). Some other papers (Philippon and Schnabl, 2010, Bhattacharya and Nyborg,

2010, among others) focus on speciﬁc claims through which bank bailouts can be structured

to limit these frictions.

A large body of existing literature in banking considers that bank bailouts are inherently

a problem of time consistency and induce moral hazard at individual-bank level (Mailath

and Mester, 1994) and at collective level through herding (Penati and Protopapadakis, 1988,

Acharya and Yorulmazer, 2007). Aghion, Bolton and Fries (1999) consider the cost that

bank debt restructuring can in some cases delay the recognition of loan losses. Brown and

Dinc (2009) show empirically that the governments are more likely to rescue a failing bank

when the banking system, as a whole, is weak.

A small part of this literature, however, does consider ex-post costs of bailouts. Notably,

Diamond and Rajan (2005, 2006) study how bank bailouts can take away a part of the

aggregate pool of liquidity from safe banks and endanger them too. Acharya and Yorulmazer

(2007, 2008) model, in a reduced-form manner, a cost of bank bailouts to the government

or regulatory budget that is increasing in the quantity of bailout funds. They provide

taxation-related ﬁscal costs as a possible motivation. Panageas (2010a,b) considers the

optimal taxation to fund bailouts in a continuous-time dynamic setting, also highlighting

when banks might be too big to save.

In the theoretical literature on sovereign defaults, Bulow and Rogoﬀ (1989a, 1989b) ini-

tiated a body of work that focused on ex-post costs to sovereigns of defaulting on external

debt, e.g., due to reputational hit in future borrowing, imposition of international trade

sanctions and conditionality in support from multi-national agencies. Broner and Ventura

36

(2005), Broner, Martin and Ventura (2007), Acharya and Rajan (2010) and Gennaioli, Mar-

tin and Rossi (2010), among others, consider a collateral damage to the ﬁnancial institutions

and markets when a sovereign defaults. They employ this as a possible commitment device

that gives the sovereign “willingness to pay” its creditors. Our model considers both of these

eﬀects, an ex-post deadweight cost of sovereign default in external markets as well as an

internal cost to the ﬁnancial sector through bank holdings of government bonds.

One strand of recent empirical work focuses on the distortionary design of bank bailout

packages. Acharya and Sundaram (2009) document how the loan guarantee program of the

Federal Deposit Insurance Corporation in the Fall of 2008 was charged in a manner that

favored weaker banks at the expense of safer ones, producing a downward revision in CDS

spreads of the former. Veronesi and Zingales (2009) conduct an event study and speciﬁcally

investigate the U.S. government intervention in October 2008 through TARP and calculate

the beneﬁts to banks and costs to taxpayers. They ﬁnd that the government intervention

increased the value of banks by over $100 billion, primarily of bank creditors, but also

estimate a tax payer cost between $25 to $47 billion. Panetta et al. (2009) and King (2009)

assess the Euro zone bailouts and reach the conclusion that while bank equity was wiped out

in most cases, bank creditors were backstopped reﬂecting a waiting game on part of bank

regulators and governments.

Another strand of recent empirical work relating ﬁnancial sector and sovereign credit

risk during the ongoing crisis shares some similarity to the very recent papers on this theme.

Sgherri and Zoli (2009) and Attinasi, Checherita and Nickel (2009) focus on the eﬀect of

bank bailout announcements on sovereign credit risk measured using CDS spreads. Some

of their evidence mirrors our descriptive evidence. Dieckmann and Plank (2009) analyze

sovereign CDS of developed economies around the crisis and document a signiﬁcant rise

in co-movement following the collapse of Lehman Brothers. Demirguc-Kunt and Huizinga

(2010) do an international study of equity prices and CDS spreads around bank bailouts and

show that some large banks may be too big to save rather than too big to fail. Our analysis

corroborates and complements some of this work. In particular, our empirical investigation

of banking sector holdings of government debt and how this introduces a linkage between

bank CDS and sovereign CDS is novel.

Finally, Reinhart and Rogoﬀ (2009a, b) and Reinhart and Reinhart (2010) document that

economic activity remains in deep slump “after the fall” (that is, after a ﬁnancial crisis), and

private debt shrinks signiﬁcantly while sovereign debt rises, especially beyond a threshold of

90% debt to GDP ratio of the sovereign. These eﬀects are potentially all consistent with our

37

model of how ﬁnancial sector bailouts aﬀect sovereign credit risk and economic growth.

6 Conclusion

This paper examines the intimate and intricate link between bank bailouts and sovereign

credit risk. We develop a model in which the government faces an important trade-oﬀ:

bank bailouts ameliorate the under-investment problem in the ﬁnancial sector but reduce

investment incentives in the non-ﬁnancial sector due to costly future taxation. In the short-

run, bailouts are funded through the issuance of government bonds, which dilutes the value

of existing government bonds and creates a two-way feedback mechanism because ﬁnancial

ﬁrm hold government bonds for liquidity purposes. We also provide supporting evidence for

our model using data from the ﬁnancial crisis of 2007-10. In particular, we document that

developed country governments transferred credit risk from the ﬁnancial sector to taxpayers

during the height of the crisis in October 2008. Using credit ratings data and data on

sovereign bond holdings from the European bank stress test in May 2010, we ﬁnd that

sovereign credit risk in turn aﬀected bank credit risk.

Overall, we consider the emergence of meaningful sovereign credit risk as an important

potential cost of bank bailouts. This cost is a reﬂection of the future taxation (or more

generally, even inﬂation) risk imposed on corporate and household sectors of the economy.

Such an ex-post cost of bailouts has received little theoretical attention and has also not been

analyzed much empirically. Taking cognizance of this ultimate cost of bailouts has important

consequences for the future resolution of ﬁnancial crises, the design of ﬁscal policy, and the

nexus between the two.

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41

Figure 1: Sovereign CDS and bank CDS of Ireland

0

2

0

0

4

0

0

6

0

0

8

0

0

01jan2007 01jan2008 01jan2009 01jan2010 01jan2011

date

(mean) cds (mean) countrycds

Figure 1 plots the sovereign CDS and bank CDS for Ireland in the period from 3/1/2007

to 8/31/2010. The bank CDS is computed as the unweighted average of bank CDS for

banks headquartered in Ireland (Allied Irish Bank, Anglo Irish Bank, Bank of Ireland,

and Irish Life and Permanent). The data are from Datastream.

Figure 2: Marginal Gain and Loss of Raising T (Certainty Case)

0.05 0.1 0.15 0.2 0.25 0.3

τ

d

G

/

d

T

0

a

n

d

d

L

/

d

τ

dG vs. dL

Value of Government’s Objective Function

0.05 0.1 0.15 0.2 0.25 0.3

τ

v

a

l

.

g

o

v

.

o

b

j

Gov. Objective Value

The top panel of Figure 2 plots the marginal gain (dG/dT ) of raising tax revenues

(solid line and dash-dot line) and the marginal loss (dL/dT , dashed line) as functions

of T for the certainty model of Section 3.3. The dash-dot line corresponds to a higher

level of existing government debt, N

D

, than the solid line. The bottom panel of the

Figure shows the resulting value of the government’s objective function (equation (3)),

with the the solid and dash-dot line corresponding to their counterparts in the top

panel. The plots correspond to a parameterization of the model where

˜

A

1

∼ U[0, 1],

L

1

= 0.5, α = 1, ϑ = 0.3, γ = 0.2, β = 0.5, m = 1.3, D = 0.02, k = 0, and N

D

= 0.25

(solid line).

Figure 3: The Default Boundary (Certainty Case)

Default and No−Default Regions

L

1

N

D

Default

No Default

0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

0

0.05

0.1

0.15

0.2

0.25

0.3

Figure 3 shows the Default and No-Default Regions in the space of L

1

×N

D

(ﬁnancial

sector leverage/debt overhang × pre-existing sovereign debt) for the certainty model

parameterized as in Figure 2. The black curve separating these two regions gives the

Default Boundary.

Figure 4: Marginal Gain and Loss of Increasing H

0.8 1 1.2 1.4 1.6 1.8 2 2.2 2.4 2.6

H

d

G

/

d

H

a

n

d

d

L

/

d

H

dG vs. dL

Value of Government’s Objective Function

0.8 1 1.2 1.4 1.6 1.8 2 2.2 2.4 2.6

H

value of gov. objective

The top panel of Figure 4 plots the marginal gain of increasing H while holding constant

T , dG/dH (solid line and dash-dot line) and the resulting marginal increase in expected

dead-weight default cost D

dpdef

dH

(dashed line). Uncertainty over growth/tax revenues,

˜

R

V

, is assumed to have a uniform distribution. The dash-dot line corresponds to a

higher level of L

1

than for the solid line. The bottom panel of the Figure shows the

resulting value of the government’s objective function, with the the solid and dash-dot

line corresponding to their counterparts in the top panel. The plots correspond to a

parameterization of the model where

˜

R

V

∼ U[0.6, 1.4],

˜

A

1

∼ U[0, 1], L

1

= 0.5 (solid

line), α = 1, ϑ = 0.3, γ = 0.2, β = 0.5, m = 1.3, D = 0.06, k = 0, and N

D

= 0.25.

Figure 5: Comparative Statics for L

1

0.4 0.6 0.8

L

1

τ

0.4 0.6 0.8

L

1

H

0.4 0.6 0.8

L

1

T

0

0.4 0.6 0.8

L

1

P

0

Comparative Statics for N

D

0.1 0.2 0.3 0.4

N

D

τ

0.1 0.2 0.3 0.4

N

D

H

0.1 0.2 0.3 0.4

N

D

T

0

0.1 0.2 0.3 0.4

N

D

P

0

Figure 5 plots the equilibrium values of T (expected tax revenue), H, T

0

(the transfer),

and P

0

(price of sovereign bond) as L

1

(top panel) and N

D

(bottom panel) are varied.

The dotted line in the plots represents the point at which total default (H → ∞)

is optimal, resulting in a discontinuity in the plot. The parameters of the model

correspond to those in Figure 4.

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Figure 9: Correlation between Sovereign CDS and Public Debt before and after bank bailouts

Figure 9 shows the correlation between sovereign CDS and public liabilities (as a per-

centage of GDP) for Western European countries before and after the bank bailouts.

The top ﬁgure shows no correlation before the bailouts (as of 3/1/2007). The bottom

ﬁgure shows a strong correlation after the bank bailouts (as of 3/1/2010). The data

are from Datastream and the OECD Economic database.

Table 1: Summary Statistics

The sample show cross-sectional and time-series summary statistics for the bank risk sample. The sample

includes all European, U.S., and Australian banks with available data on bank CDS and share prices. The

data are the weekly level. Panel A shows summary statistics for the week of July 1

st

, 2007. Panel B

shows summary statistics for the period from January 1

st

, 2007 to August 31

st

, 2010.

Panel A: Cross-Section (7/1/2007)

# Mean Std.Dev

50

th

Percentile

5

th

Percentile

95

th

Percentile

Assets ($ billion)

81 589.3

594.9 362.6 77.9 1,896.9

Equity ($ billion)

81 26.8

29.3 20.2 3.5 112.4

Equity Ratio (%) 81 5.1 2.7 4.8 1.9 10.0

Tier 1 Ratio (%)

66 8.5

1.9 8.2 6.5 12.4

Bank CDS (bp)

75 21.8

13.4 10.5 6.5 41.0

Sovereign CDS (bp)

56 6.6 11.5 2.0 1.5 52.1

Panel B: Time-Series

Pre-Bailout Period (1/1/2007-8/31/2008)

# Mean Std.Dev

50

th

Percentile

5

th

Percentile

95

th

Percentile

Bank CDS (bp)

3,633 98.2 159.4 65.5 6.6 293.3

Sovereign CDS (bp)

3,633 12.1 10.9 8.8 1.6 37.2

CDS Volatility

3,633 0.001 0.028 0.001 -0.038 0.042

Bank Stock Return (%)

2,859 -0.008 0.079 -0.004 -0.102 0.082

∆ Bank CDS (%)

3,630 0.027 0.249 0.017 -0.281 0.324

∆ Sovereign CDS (%)

3,610 0.016 0.341 0.018 -0.302 0.333

∆ CDS Market Index (%)

3,633 0.015 0.138 0.000 -0.199 0.217

Bailout Period (9/1/2008-10/31/2008)

Bank CDS (bp)

606 301.3 615.1 138.7 65.9 727.5

Sovereign CDS (bp)

606 33.6 21.9 28.2 9.5 81.8

CDS Volatility

606 0.067 0.103 0.058 -0.079 0.278

Bank Stock Return (%)

455 -0.074 0.246 -0.033 -0.364 0.140

∆ Bank CDS (%)

605 0.041 0.378 0.032 -0.515 0.518

∆ Sovereign CDS (%)

606 0.137 0.177 0.101 -0.095 0.519

∆ CDS Market Index (%)

606 0.055 0.168 0.043 -0.267 0.373

Post-Bailout (31/10/2008 - 31/8/2010)

Bank CDS (bp)

6,496 194.1 178.9 131.5 65.5 567.8

Sovereign CDS (bp)

6,496 90.8 100.0 58.7 24.7 244.7

CDS Volatility

6,496 -0.002 0.034 -0.002 -0.045 0.043

Bank Stock Return (%)

4,814 0.003 0.100 0.003 -0.122 0.136

∆ Bank CDS (%)

6,495 0.001 0.129 -0.003 -0.174 0.174

∆ Sovereign CDS (%)

6,495 0.000 0.122 -0.002 -0.207 0.208

∆ CDS Market Index (%)

6,496 -0.005 0.089 -0.009 -0.124 0.130

Table 2: Emergence of Sovereign Credit Risk

This table shows the relation between sovereign credit risk, public debt, and bank quality. The sample includes all Eurozone countries and

Australia, Denmark, Great Britain, Sweden, and Switzerland with publicly available data on sovereign and bank CDS. The data are at the country-

level. The independent variable in Columns (1) and (2) is the sovereign CDS before the bank bailouts (as of 1/1/2008). Columns (1) and (2)

control for Public Debt measured as General Government Gross Financial Liabilities as percentage of GDP (collected from the OECD Economic

Outlook). Column (2) controls for average bank quality measured as the average banks CDS before the bank bailouts (as of 9/22/2008). The

independent variable in Columns (3) and (4) is the sovereign CDS after the bank bailouts (as of 3/31/2010). The dependent variables are the same

as in Columns (1) and (2), respectively. The independent variable in column (5) is the change in public debt from June 2008 to June 2010. The

dependent variable is the average bank quality. The independent variable in column (6) is public debt in June 2010. The dependent variables are

the public debt in June 2008 and average bank quality. We report robust standard errors. ** 1% significant, * 5% significant, and + 10%

significant

Log (Sovereign CDS) % Public Debt

Pre-Bailout Post-Bailout Around Bailout Post-Bailout

1/1/2008 3/31/2010 ∆ 2010-2008 3/31/2010

% Public Debt (June 2008) 0.006 0.005 0.015* 0.013+ 1.107**

(0.004) (0.005) (0.006) (0.007) (0.144)

Log (Average Bank CDS Sep 2008) 0.311 0.965* 20.118+ 21.726+

(0.208) (0.357) (10.168) (11.555)

Constant 2.137** 0.601 3.112** -1.593 -86.920 -101.548

(0.320) (1.154) (0.401) (2.019) (49.456) (60.923)

Observations 15 14 17 15 15 15

R-squared 0.134 0.171 0.261 0.488 0.364 0.843

Table 3: Change in Bank and Sovereign Credit Risk

This table shows the effect of sovereign credit risk on bank credit risk during the financial crisis. The sample includes all European, U.S., and

Australian banks with available data on bank CDS and share prices. The data are at the weekly level. Columns (1) to (3) cover the pre-bailout

period (1/1/2007-31/8/2010), Columns (4) to (6) cover the bailout period (9/1/2008-10/31/2008), and Columns (7) to (9) cover the post-bailout

period (November 2008 to August 2010). The dependent variable is the weekly change in the natural logarithm of bank CDS. The main

independent variable is the weekly change in the sovereign CDS. The sovereign CDS is assigned based on the country where the bank is

headquartered. The control variables are the change in CDS market index, volatility, and bank stock return. Columns (2), (3), (5), (6), (8), and (9)

include week fixed effects. Column (3), (6), (9) include bank fixed effects and interactions of bank fixed effects with volatility, bank stock return,

and the CDS Market index. The standard errors are clustered at the bank-level. ** 1% significant, * 5% significant, and + 10% significant

∆ Log(Bank CDS)

Period Pre-Bailout (Jan 07-Aug 08) Around Bailout (Sep-Oct 08) Post-Bailout (Nov 08-Sep 10)

(1) (2) (3) (4) (5) (6) (7) (8) (9)

∆ Log(Sovereign CDS)

0.023* 0.015 0.019 0.026 -0.403+ -0.430 0.163** 0.079** 0.080**

(0.010) (0.014) (0.015) (0.082) (0.232) (0.287) (0.019) (0.030) (0.027)

∆ Log(CDS Market Index) 0.860** 0.932** 0.689**

(0.041) (0.094) (0.027)

∆ Volatility Index

0.214 -0.539** 0.122*

(0.155) (0.081) (0.050)

Week FE N Y Y N Y Y N Y Y

Interactions N N Y N N Y N N Y

Observations

3,508 3,508 3,508 577 577 577 7,086 7,086 7,086

Banks

84 84 84 71 71 71 84 84 84

R-squared

0.171 0.253 0.387 0.134 0.308 0.504 0.316 0.384 0.441

Table 4: Change in Bank and Sovereign Credit Risk

This table shows the effect of sovereign credit risk on bank credit risk during the financial crisis. The sample includes all European, U.S., and

Australian banks with available data on bank CDS and share prices. The data are at the weekly level. Columns (1) to (3) cover the pre-bailout

period (1/1/2007-31/8/2010), Columns (4) to (6) cover the bailout period (9/1/2008-10/31/2008), and Columns (7) to (9) cover the post-bailout

period (November 2008 to August 2010). The dependent variable is the weekly change in the natural logarithm of bank CDS. The main

independent variable is the weekly change in the sovereign CDS. The sovereign CDS is assigned based on the country where the bank is

headquartered. The control variables are the change in CDS market index, volatility, and bank stock return. Columns (2), (3), (5), (6), (8), and (9)

include week fixed effects. Column (3), (6), (9) include bank fixed effects and interactions of bank fixed effects with volatility, bank stock return,

and the CDS Market index. The standard errors are clustered at the bank-level. ** 1% significant, * 5% significant, and + 10% significant

∆ Log(Bank CDS)

Period Pre-Bailout (Jan 07-Aug 08) Around Bailout (Sep-Oct 08) Post-Bailout (Nov 08-Sep 10)

(1) (2) (3) (4) (5) (6) (7) (8) (9)

∆ Log(Sovereign CDS)

0.019* 0.008 0.014 -0.020 -0.236 -0.235 0.150** 0.100** 0.105**

(0.009) (0.013) (0.015) (0.096) (0.153) (0.200) (0.025) (0.034) (0.030)

Bank Stock Return

-0.142 -0.062 -0.255+ -0.295* -0.174** -0.154**

(0.118) (0.106) (0.132) (0.147) (0.034) (0.036)

∆ Log(CDS Market Index)

0.929** 0.848** 0.662**

(0.043) (0.123) (0.032)

∆ Volatility Index

0.043 -0.711** 0.030

(0.120) (0.096) (0.051)

Week FE N Y Y N Y Y N Y Y

Interactions N N Y N N Y N N Y

Observations

2,745 2,745 2,745 437 437 437 5,278 5,278 5,278

Banks

63 63 63 53 53 53 60 60 60

R-squared

0.224 0.308 0.481 0.208 0.403 0.728 0.359 0.424 0.491

Table 5: Change in Bank and Sovereign Credit Risk (by Tier 1 Capital)

This table shows the effect of sovereign credit risk on bank credit risk during the financial crisis. The sample includes all European, U.S., and

Australian banks with available data on bank CDS and share prices. The data are at the weekly level. Columns (1) to (3) cover the pre-bailout

period (1/1/2007-31/8/2010), Columns (4) to (6) cover the bailout period (9/1/2008-10/31/2008), and Columns (7) to (9) cover the post-bailout

period (November 2008 to August 2010). The dependent variable is the weekly change in the natural logarithm of bank CDS. The Tier 1 capital

ratio is the regulatory bank capital ratio. All other variables are defined in Tables 3 to 5. The regression includes the Tier 1 capital ratio and an

interaction between the Tier1 capital ratio and the change in sovereign CDS. All other controls are the same as in Table5. The standard errors are

clustered at the bank-level. ** 1% significant, * 5% significant, and + 10% significant

∆ Log(Bank CDS)

Period Pre-Bailout (Jan 07-Aug 08) Around Bailout (Sep-Oct 08) Post-Bailout (Nov 08-Sep 10)

(1) (2) (3) (4) (5) (6) (7) (8) (9)

∆ Log(Sovereign CDS)*Tier 1

0.648 0.340 1.014 -6.265* -6.730+ -4.011 -1.765 -1.610 -2.824*

(0.882) (0.712) (1.035) (2.493) (3.823) (12.976) (1.470) (1.423) (1.360)

∆ Log(Sovereign CDS)

-0.031 -0.019 -0.079 0.575* 0.437 0.032 0.337* 0.317* 0.368**

(0.072) (0.066) (0.096) (0.237) (0.336) (1.182) (0.127) (0.126) (0.118)

Tier 1

-15.118 -13.492 61.937 67.087 -1.589 -2.114

(30.883) (32.400) (108.792) (78.028) (8.224) (8.568)

Stock Return -0.347** -0.335** -0.117 -0.054 -0.165** -0.134**

(0.095) (0.115) (0.139) (0.140) (0.037) (0.043)

Other Controls Y Y Y Y Y Y Y Y Y

Week FE N Y Y N Y Y N Y Y

Interactions N N Y N N Y N N Y

Observations

2,256 2,256 2,256 351 351 351 4,163 4,163 4,163

Bank

48 48 48 41 41 41 47 47 47

R-squared

0.261 0.345 0.510 0.353 0.528 0.804 0.380 0.449 0.517

Table 6: Bank Stock Return and Change in Sovereign Credit Risk

This table shows the effect of sovereign credit risk on bank stock returns during the financial crisis. The sample includes all European, U.S., and

Australian banks with available data on bank CDS and share prices. The data are at the weekly level. Columns (1) to (3) cover the pre-bailout

period (1/1/2007-31/8/2010), Columns (4) to (6) cover the bailout period (9/1/2008-10/31/2008), and Columns (7) to (9) cover the post-bailout

period (November 2008 to August 2010). The dependent variable is the weekly bank stock return. The main independent variable is the weekly

change in the sovereign CDS. The sovereign CDS is assigned based on the country where the bank is headquartered. The control variables are the

change in CDS market index and volatility. Columns (2), (3), (5), (6), (8), and (9) include week fixed effects. Column (3), (6), (9) include bank

fixed effects and interactions of bank fixed effects with volatility and the CDS Market index. The standard errors are clustered at the bank-level.

** 1% significant, * 5% significant, and + 10% significant

Bank Stock Return

Period Pre-Bailout (Jan 07-Aug 08) Around Bailout (Sep-Oct 08) Post-Bailout (Nov 08-Sep 10)

(1) (2) (3) (4) (5) (6) (7) (8) (9)

∆ Log(Sovereign CDS)

-0.011** -0.002 -0.002 -0.040 0.041 0.114 -0.177** -0.054* -0.068**

(0.004) (0.002) (0.002) (0.035) (0.075) (0.114) (0.026) (0.026) (0.026)

∆ Log(CDS Market Index)

-0.106** -0.474** -0.243**

(0.015) (0.078) (0.017)

∆ Volatility Index

-0.368** -0.317** -0.761**

(0.070) (0.082) (0.057)

Week FE N Y Y N Y Y N Y Y

Bank FE N N Y N N Y N N Y

Interactions N N Y N N Y N N Y

Observations

2,895 2,895 2,895 446 446 446 5,324 5,324 5,324

Banks

65 65 65 54 54 54 60 60 60

R-squared

0.070 0.240 0.311 0.118 0.212 0.564 0.285 0.488 0.533

Table 7: Summary Statistics of European Bank Stress Test Sample

The table shows summary statistics for all banks that participated in the EU Bank Stress Tests from July

2010. The data was collected from the website of the Committee of European Banking Regulators and

nation websites of the respective bank regulators. The sovereign holdings are computed as the total value

of sovereign holdings relative to risk-weighted assets. We report both the gross and net exposure as

reported to bank regulators. The share of trading book and banking book are the share of sovereign

holdings held in the respective book. The shares are computed based on gross exposure (net exposure

was not reported).

Sovereign Holdings

Euro Bank Stress Tests Sample, March 31, 2010

N Mean Std.Dev

50th

Percentile

5th

Percentile

95th

Percentile

(1) (2) (3) (4) (5) (6)

Bank Characteristics

Risk-weighted Assets (EUR

million) 91 126,337 179,130 63,448 3,269 493,307

Tier 1 Capital Ratio (%) 91 10.2 2.4 9.8 7.2 14.4

Sovereign Exposure

Sovereign Holdings (gross,

EUR million) 91 20,668 27,948 7,930 105 81,765

Sovereign Holdings (net,

EUR million) 91 19,719 27,329 6,960 105 78,959

Home Sovereign Holdings

(gross, EUR million) 91 11,493 14,422 5,774 182 42,800

Home Sovereign Holdings

(net, EUR million) 91 11,023 13,956 5,348 117 42,800

Home Share (%) 91 69.4 30.0 81.6 18.9 100

Greek Sovereign Holdings 91 669 2,844 0 0 5,601

Share Banking Book (%) 91 84.9 19.9 92.2 35.4 100.0

Table 8: Summary Statistics of European Bank Stress Test Sample

The table shows regression of change in bank CDS on change in exposure to sovereign bank holdings.

The sovereign bond holdings data were collected from the website of the Committee of European

Banking Regulators and nation websites of the respective bank regulators. We construct the exposure

variable as the weighted average of country CDS with sovereign holdings as weights. Changes are

computed as log changes. The data covers the period from 3/1/2010 to 4/30/2010. Columns (2), (5) and

(6) include bank fixed effects. Column (3) includes week fixed effects. Column (4) to (6) include day

fixed effect. The exposure variable in Column (6) excludes German bonds. The standard errors are

clustered at the bank-level (51 banks). ** 1% significant, * 5% significant, and +10% significant

Change in Bank CDS

Sample All All All All All

Excluding

Germany

(1) (2) (3) (4) (5) (6)

Change in Sovereign

Exposure 0.325** 0.326** 0.261** 0.141** 0.135** 0.137**

(0.027) (0.028) (0.027) (0.049) (0.046) (0.046)

Bank FE N Y N N Y Y

Week FE N N Y N N N

Day FE N N N Y Y Y

Observations 2,317 2,317 2,317 2,317 2,317 2,317

Banks 51 51 51 51 51 0.357

R-squared 0.173 0.188 0.228 0.342 0.357 0.357

Adjusted R-Squared 0.173 0.170 0.224 0.329 0.329 0.329

A Pyrrhic Victory? – Bank Bailouts and Sovereign Credit Risk

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 corporate 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 onto the ﬁnancial sector, reducing the value of its guarantees and existing bond holdings and 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 for 2007-10. 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. J.E.L. Classiﬁcation: G21, G28, G38, E58, D62. Keywords: ﬁnancial crises, forbearance, deleveraging, sovereign debt, growth, credit default swaps

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Introduction

Just two and a half years ago, there was essentially no sign of sovereign credit risk in the developed economies and a prevailing view was that this was unlikely to be a concern for them in the near future. Recently, however, sovereign credit risk has become a signiﬁcant problem for a number of developed countries. In this paper, we are motivated by three closely related questions surrounding this development. First, were the ﬁnancial sector bailouts an integral factor in igniting the rise of sovereign credit risk in the developed economies? We show that they were. Second, what was the exact mechanism that caused the transmission of risks between the ﬁnancial sector and the sovereign? We propose a theoretical explanation wherein the government can ﬁnance a bailout through both increased taxation and via dilution of existing government debt-holders. The bailout is beneﬁcial; it alleviates a distortion in the provision of ﬁnancial services. However, both ﬁnancing channels are costly. When the optimal bailout is large, dilution can become a relatively attractive option, leading to deterioration in the sovereign’s creditworthiness. Finally, we ask whether there is also feedback going in the other direction– does sovereign credit risk feedback on to the ﬁnancial sector? We explain – and verify empirically – that such a feedback is indeed present, due to the ﬁnancial sector’s implicit and explicit holdings of sovereign bonds. Our results call into question the usually implicit assumption that government resources are vastly deep and that the main problem posed by bailouts is primarily that of moral hazard – that is, the distortion of future ﬁnancial sector incentives. While the moral hazard cost is certainly pertinent, our conclusion is that bailout costs are not just in the future. They are tangible right around the timing of bailouts and are priced into the sovereign’s credit risk and cost of borrowing. Thus, aggressive bailout packages that stabilize ﬁnancial sectors in the short run but ignore the ultimate taxpayer cost might end up being a Pyrrhic victory. Motivation: The case of Irish bailout. 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 2

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 suggests that the risk of the ﬁnancial sector had been substantially transferred to the government balance sheet, a cost that Irish taxpayers must eventually bear. Viewed in the Fall of 2010, this cost rose to dizzying heights prompting economists to wonder if the precise manner in which bank bailouts were awarded have rendered the ﬁnancial sector rescue exorbitantly expensive. Just one of the Irish banks, Anglo Irish, has cost the government up to Euro 25 bln (USD 32 bln), amounting to 11.26% of Ireland’s Gross Domestic Product (GDP). Ireland’s ﬁnance minister Brian Lenihan justiﬁed the propping up of the bank “to ensure that the resolution of debts does not damage Ireland’s international credit-worthiness and end up costing us even more than we must now pay.” Nevertheless, rating agencies and credit markets revised Ireland’s ability to pay future debts signiﬁcantly downward. The original bailout cost estimate of Euro 90 bln was re-estimated to be 50% higher and the Irish 10-year bond spread over German bund widened signiﬁcantly, ultimately leading to a bailout of Irish government by the stronger Eurozone countries.1 This episode is not isolated to Ireland though it is perhaps the most striking case. In fact, a number of Western economies that bailed out their banking sectors in the Fall of 2008 have experienced, in varying magnitudes, similar risk transfer between their ﬁnancial sector and government balance-sheets. Our paper develops a theoretical model and provides empirical evidence that help understand this interesting phenomenon. Model. Our theoretical model consists of two sectors of the economy – “ﬁnancial” and “corporate” (more broadly this includes also the household and other non-ﬁnancial parts of the economy), and a government. The two sectors contribute jointly to produce aggregate output: the corporate sector makes productive investments and the ﬁnancial sector invests in intermediation “eﬀort” (e.g., information gathering and capital allocation) that enhance the return on corporate investments. Both sectors, however, face a potential under-investment problem. The ﬁnancial sector is leveraged (in a crisis, it may in fact be insolvent) and underinvests in its contributions due to the well-known debt overhang problem (Myers, 1977). For simplicity, the corporate sector is un-levered. However, if the government undertakes a

See “Ireland’s banking mess: Money pit – Austerity is not enough to avoid scrutiny by the markets”, the Economist, Aug 19th 2010; “S&P downgrades Ireland” by Colin Barr, CNNMoney.com, Aug 24th 2010; and, “Ireland stung by S&P downgrade”, Reuters, Aug 25th, 2010.

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“bailout” of the ﬁnancial sector, in other words, makes a transfer from the rest of the economy that results in a net reduction of the ﬁnancial sector debt, then the transfer must be funded in the future (at least in part) through taxation of corporate proﬁts. Such taxation, assumed to be proportional to corporate sector output, induces the corporate sector to under-invest. A government that is fully aligned with maximizing the economy’s current and future output determines the optimal size of the bailout. We show that tax proceeds that can be used to fund the bailout have, in general, a Laﬀer curve property, so that the optimal bailout size and tax rate are interior. The optimal tax rate that the government is willing to undertake for the bailout is greater when the ﬁnancial sector’s debt overhang is higher and its relative contribution (or size) in output of the economy is larger. In practice, governments fund bailouts in the short run by borrowing or issuing bonds, which are repaid by future taxation. There are two interesting constraints on the bailout size that emerge from this observation. One, the greater is the legacy debt of the government, the lower is its ability to undertake a bailout. This is because the Laﬀer curve of tax proceeds leaves less room for the government to increase tax rates for repaying its bailout-related debt. Second, the announcement of the bailout lowers the price of government debt due to the anticipated dilution from newly issued debt. Now, if the ﬁnancial sector of the economy has assets in place that are in the form of government bonds, the bailout is in fact associated with some “collateral damage” for the ﬁnancial sector itself. Illustrating the possibility of such a two-way feedback is a novel contribution of our model. To get around these constraints, the government can potentially undertake a strategic default. Assuming that there are some deadweight costs of such default, for example, due to international sanctions or from being unable to borrow in debt markets for some time, we derive the optimal boundary for sovereign default as a function of its legacy debt and ﬁnancial sector liabilities. This boundary explains that a heavily-indebted sovereign faced with a heavily-insolvent ﬁnancial sector will be forced to “sacriﬁce its credit rating” to save the ﬁnancial sector and at the same time sustain economic growth. We then extend the model to allow for uncertainty about the realized output growth of the corporate sector.This introduces a possibility of solvency-based default on government debt. Interestingly, given the collateral damage channel, an increase in uncertainty about the sovereign’s economic output not only lowers its own debt values but also increases the ﬁnancial sector’s risk of default. This is because the ﬁnancial sector’s government bond holdings fall in value, and in an extension of the model, so do the value of the government guarantees accorded to the ﬁnancial sector as a form of bailout. In turn, these channels 4

we examine sovereign and bank CDS in the period from 2007 to 2010 and ﬁnd three distinct periods. This evidence is consistent with a signiﬁcant increase in the default risk of the banking sector with little eﬀect on sovereigns in the prebailout period. The second period covers the bank bailouts starting with the announcement of a bailout in Ireland in late September 2008 and ending with a bailout in Sweden in late October 2008. We document that on average Eurozone banks stress-tested in 2010 held Eurozone government bond holdings that were as large as onesixth of their risk-weighted assets. we see a large. sustained rise in bank CDS as the ﬁnancial crisis develops. we ﬁnd a signiﬁcant decline in bank CDS across all countries and a corresponding increase in sovereign CDS. This evidence suggests that the banks and sovereigns share the default risk after the announcement of banks bailouts and that the risk is increasing in the relative size of countries’ public debt.induce a post-bailout co-movement between the ﬁnancial sector’s credit risk and that of the sovereign. The third period covers the period after the bank bailouts and until 2010. We ﬁnd that both sovereign and bank CDS increased during this period and that the increase was larger for countries with signiﬁcant public debt ratios. The ﬁrst period covers the start of the ﬁnancial crisis in January 2007 until the bankruptcy of Lehman Brothers. We conﬁrm all of the above results also in our regression analysis linking levels and changes in ﬁnancial sector CDS to levels and changes. Finally. However. we show that bank CDS co-move with sovereign CDS on banks’ holdings 5 . This evidence suggests that bank bailouts produced a transfer of default risk from the banking sector to the sovereign. we collect bank-level data on holdings of diﬀerent sovereign government bonds released as part of the bank stress tests conducted for European banks in 2010. In our non-parametric analysis. Our empirical work analyzes this two-way feedback between the ﬁnancial sector and sovereign credit risk. Consistent with the economic importance of the collateral damage channel. We also conﬁrm model’s implications that banks with higher leverage experience a stronger relationship between sovereign and bank credit risks after the bailouts. respectively. Empirics. During this one-month period. in support of the collateral damage channel as being potentially relevant for the co-movement between ﬁnancial sector and sovereign CDS. of sovereign CDS in the three periods. sovereign CDS spreads remains very low. Our analysis focuses mainly on the Western European economies during the ﬁnancial crisis of 2007-10. Across all Western economies. even though the immediate eﬀect of the bailout is to lower the ﬁnancial sector’s credit risk and raise that of the sovereign.

L1 denotes the liabilities of the ﬁnancial sector. Freddie Mac) and perhaps also the value of explicit and implicit government guarantees or support. In addition. while A1 represents the payoﬀ of the other assets held by the ﬁnancial sector.g. the variable T0 represents the value of the time 0 transfer made by the government to the ﬁnancial sector and is discussed further below. All agents are risk-neutral. To produce s0 units. denoted A1 and AG . Financial sector: The operator of the ﬁnancial sector solves the following problem. 2 Model There are three time periods in the model: t = 0. 2 While we refer to government claims principally as government bonds. The payoﬀ and value of government bonds is discussed below. It receives the payoﬀ from its eﬀorts only if the value of assets exceeds liabilities at t = 1. with ws determined in equilibrium. as a continuously valued random variable that is realized at t = 1 and takes values in [0. The productive economy consists of two parts. AG is the value of ˜ the ﬁnancial sector’s holdings of a fraction kA of outstanding government bonds. and 2. which are due (mature) at t = 1. We assume that c (s0 ) > 0 and c (s0 ) > 0. a ﬁnancial sector and a non-ﬁnancial sector. Section 2 presents our theoretical analysis. Section 6 concludes. Finally. All proofs not in the main text are in the online Appendix. ∞). Section 5 discusses the related literature. the amount of ﬁnancial services to supply at t = 1 in order to maximize his expected payoﬀ at t = 1. which is to choose. at t = 0.. which is risky. net of the eﬀort cost required to produce these services: max E0 s s0 ˜ ws ss − L1 + A1 + AG + T0 × 1{−L1 +A1 +AG +T0 >0} − c(ss ) . Fannie Mae. The remainder of the paper is organized as follows. a broader interpretation can include claims on quasi-governmental agencies (e. Section 4 provides empirical evidence. The 0 ﬁnancial sector earns revenues at the rate of ws per unit of ﬁnancial service supplied. There ˜ are two types of assets held by the ﬁnancial sector. The ﬁnancial sector has both liabilities and assets on its books. This solvency condition ˜ is given in equation (1) by the indicator function for the expression −L1 + A1 + AG + T0 > 0. 1.of government bonds. 6 . there is a government and a representative consumer. the operator of the ﬁnancial sector expends c(s0 ) units of eﬀort. ˜ 0 0 (1) where ss is the amount of ﬁnancial services supplied by the ﬁnancial sector at t = 1.2 We model the payoﬀ ˜ A1 .

whose payoﬀ is realized at t = 2. the government issues bonds. both new and outstanding. debtholders receive ownership of all ﬁnancial sector assets and wage revenue. which induces it to supply more ﬁnancial services. We let ND denote the number of bonds that the government has issued in the past – its outstanding stock of debt. at an incremental cost of (K1 − K0 ). The expectation at t = 1 of ˜ this payoﬀ is V (K1 ) = E1 [V (K1 )] and. that it then transfers to the balance sheet of the ﬁnancial sector. In particular. Government: The government’s objective is to maximize the total output of the economy and hence the welfare of the consumer. A proportion θ0 of the payoﬀ of the continuation project is taxed by the government to pay its debt. sd ) − ws sd + (1 − θ0 )V (K1 ) − (K1 − K0 ) 0 0 (2) sd . and the capital stock.In case of insolvency. sd . 3 7 . These bonds are repaid with taxes levied on the non-ﬁnancial sector at a tax-rate of θ0 . At t = 1. which would provide an additional channel for wages to feed back into the probability of solvency. This project represents the future or continuation value of the non-ﬁnancial sector and is in general subject to uncertainty. as we explain next. It does this by reducing the debt-overhang problem of the ﬁnancial sector. which occur at t = 1 and t = 2: ˜ max E0 f (K0 . ND . the non-ﬁnancial sector is faced with a decision of ˜ how much capital K1 to invest. We assume that V (K1 ) > 0 and V (K1 ) < 0.3 Non-ﬁnancial sector: The non-ﬁnancial sector comes into t = 0 with an existing capital stock K0 . the tax rate θ0 is set by the government at t = 0 ˜ and is levied at t = 2 upon realization of the payoﬀ V (K1 ). so the face value of outstanding debt equals the number of bonds. K 1 0 The function f is the production function of the non-ﬁnancial sector. which takes as inputs at t = 0 the ﬁnancial services it demands. to produce consumption 0 goods at t = 1. For simplicity. we assume that f is increasing in both arguments and concave. we choose to abstract from this to avoid the additional complexity. The government issues NT new Note that we could include the wage revenues in the solvency indicator function. Although such a channel would reinforce the mechanism at work in the model. in a project V . K0 . is a function of the investment K1 . Its objective is to maximize the sum of the expected values of its net payoﬀs. thereby increasing output. To achieve this. We assume that the government credibly commits to this tax rate. so that the expected payoﬀ is increasing but concave in investment. bonds have a face value of one. as indicated. Moreover. The output of f is deterministic.

In that case.bonds to accomplish the transfer to the ﬁnancial sector. respectively. it pays out all the tax revenue raised to bondholders. On the other hand. the consumer chooses optimal portfolio allocations. NT where s0 is the equilibrium provision of ﬁnancial services. {ni }. government bond holdings. it will have less to lose from default. just rebates them to the consumer. let P0 denotes the price of government bonds. Since the representative consumer is assumed to be risk-neutral. If a country’s reputation is already weak. At t = 0. which is determined in equilibrium. degradation of the legal system and so forth. Let P (i) and P (i) denote the price and payoﬀ of asset i. He solves a simple consumption and portfolio choice problem by allocating his wealth W between consumption. Hence. s0 ) + V (K1 ) − c(s0 ) − (K1 − K0 ) − 1def D + A1 (3) θ0 . 4 8 . that solve We can consider more generally a policy whereby the government pays only a fraction m of tax revenue ˜ and gives back any remaining tax funds to the consumer. In case of default. the sovereign incurs a ﬁxed deadweight loss of D. This implies that the value of the ﬁnancial sector’s holding of government bonds is AG = kA P0 ND . ˜ 5 Although D here is obviously reduced-form. if tax revenues fall short of NT + ND . who consumes the combined output of the ﬁnancial and non-ﬁnancial sector.4 We further assume that default incurs a deadweight loss.5 Finally. Hence. then the government defaults on its debt. We assume that the government credibly commits to this payout policy. and equity in the ﬁnancial and non-ﬁnancial sectors. the government faces the following problem: ˜ ˜ max E0 f (K0 . Consumer: The representative consumer consumes the output of the economy. asset prices equal the ex˜ pected values of asset payouts. We assume that if there are still tax revenues left over (a surplus). or equivalently. Since it will actually be optimal for the government to commit to paying bondholders all the tax revenue raised. Hence. one can think of the deadweight cost in terms of loss of government reputation internationally. Note that 1def is an indicator function that equals 1 if the government ˜ defaults (if θ0 V (K1 ) < NT + ND ) and 0 otherwise. loss of domestic government credibility. default is costly and there is an incentive to avoid it. The government’s objective is to maximize the expected utility of the representative consumer. This maximization is subject to the budget constraint: T0 = P0 NT and subject to the choices made by the ﬁnancial and non-ﬁnancial sectors. we restrict ourselves to the case m = 1. at t = 2 the government ˜ receives realized taxes equal to θ0 V (K1 ) and then uses them to pay bondholders NT + ND . the government spends them on programs for the representative consumer.

the ﬁrst order condition of the ﬁnancial sector can be written as: ws psolv − c (ss ) = 0 . 9 . 1 We assume that at the optimal ss the ﬁrst-order condition is satisﬁed. 0 (5) ∞ ˜ ˜ where psolv ≡ A p(A1 )dA. From ˆ0 ˆ0 here on. we drop the superscripts on s0 and denote the equilibrium quantity of ﬁnancial services simply by s0 . 3 Equilibrium Outcomes ˜ We begin by examining the maximization problem of the ﬁnancial sector.sd ) (6) 0 0 Since f is concave in its arguments. 0 Consider now the problem of the non-ﬁnancial sector at t = 0. P (i) = E0 [P (i)]. ∂ 2 sd 0 Henceforth. Its demand for ﬁnancial services. 0 In equilibrium the demand and supply of ﬁnancial services are the same: sd = ss .the following problem: ˜ max E0 Σi ni P (i) + (W − Σi ni P (i)) ni (4) The consumer’s ﬁrst order condition gives the standard result that equilibrium price of an ˜ asset equals the expected value of its payoﬀ. is the probability that the ﬁnancial sector is solvent at t = 1. Then. sd . let A1 be the minimum realization of A1 for which the ﬁnancial sector does not default: A1 = L1 − AG − T0 . sd ) 0 = ws . The parametric choice we will use 0 1 below for c(s0 ) is c(s0 ) = β m sm where m > 1. s0 ) = αK0 sϑ . Let p(A) denote ˜ ˜ the probability density of A. the second order condition is satisﬁed: < 0. d ∂s0 ∂ 2 f (K . Furthermore. The second-order ˆ0 condition of the ﬁnancial sector’s problem is −c (ss ) < 0. is determined by its ﬁrst-order condition: ˆ0 ∂f (K0 . we will parameterize f as Cobb-Douglas with the factor share of ﬁnancial services 1−ϑ given by ϑ: f (K0 .

an increase in the tax rate increases the tax revenue at a rate equal to V (K1 ). which reduces the marginal revenue of a tax increase. K1 . Raising taxes has two eﬀects. while the marginal cost. be denoted by T . θ0 . the tax distortion eliminates the incentive for investment and tax revenues are reduced to zero. It can be shown that since the production function V (K1 ) is concave. Hence.2 Tax Revenues: A Laﬀer Curve Next. At the extreme.3. the ﬁrst-order conditions of the ﬁnancial sector (5) and non-ﬁnancial sector (6) show how debt-overhang impacts the provision of ﬁnancial services by the ﬁnancial sector. consider the ﬁrst-order condition 10 . thereby leading to reduced investment. an increase in the tax rate θ0 captures a larger proportion of the future value of the non-ﬁnancial sector.1 Transfer Reduces Underprovision of Financial Services Taken together. the impact on tax revenue of an increase in the tax rate is given by: dK1 ∂T = V (K1 ) + θ0 V (K1 ) ∂θ0 dθ0 Note that at θ0 = 0. The marginal beneﬁt of an extra unit of ﬁnancial services to the economy is given by ws . Let the expected tax revenue. This is given by the second term on the right-hand side of the expression. we ﬁrst look at how expected tax revenue responds to the tax rate. Hence. An increase in the transfer T0 leads to an increase in the provision of ﬁnancial services since this raises the probability psolv that the ﬁnancial sector is solvent at t = 1. c (s0 ). when θ0 = 1. the future value of the non-ﬁnancial sector. this reduces the incentive of the non-ﬁnancial sector to invest in its future. The reason is that the possibility of liquidation psolv < 1 drives a wedge between the social and private marginal beneﬁt of an increase in the provision of ﬁnancial services. θ0 V (K1 ). To see this. This implies that the equilibrium allocation is sub-optimal. we obtain that Lemma 1. thereby raising tax revenues. On the one hand. The result is that as long as psolv < 1. On the other hand. tax revenues are non-monotonic in the tax rate and maximized by a tax rate strictly less than 1. as taxes are increased the incentive to invest is decreased by the tax rate. to understand the government’s problem. Formally. is less than ws if there is a positive probability of insolvency. 3. there is an under-provision of ﬁnancial services relative to the ﬁrst-best case (psolv = 1).

6 As γ γ Appendix A. To summarize.for investment of the non-ﬁnancial sector at t = 1: (1 − θ0 )V (K1 ) − 1 = 0 (7) Since V (K1 ) < 0.3 shows. γ Henceforth. is increasing (dT /dθ0 > 0) max max 2 and concave (d2 T /dθ0 < 0) on [0. as it increases from zero (no taxes). NT + ND = T . In fact. T . (7) implies that T = θt+1 γ 1−γ (1 − θt+1 ) 1−γ . θ0 . θ0 ). increase in the tax rate. This functional form is a natural choice for an increasing and concave function of K1 . it can only issue a number of bonds NT that it can pay oﬀ in full. tax revenues satisfy the Laﬀer curve property as a function of the tax rate: Lemma 2. (2) we force the government to remain solvent. since every bond has a sure payoﬀ of 1. If the government must remain solvent. 0 < γ < 1. By assumption (1). θ0 V (K1 ). Appendix A.2 provides a more structural motivation for this choice based on the calculation of a continuation value under our choice of production function. it must be the case that as the tax rate is increased. and hence by assumption (2). given its tax revenue. We make two simplifying assumptions: (1) we set to zero the variance of the ˜ realized future value of the non-ﬁnancial sector. 1). since we know that at θ0 = 1 the tax revenue is zero. The tax revenues. the marginal tax revenue decreases until it eventually becomes negative. 3. Taking the derivative with respect to θ0 by using the Implicit Function theorem gives: dK1 V (K1 ) = <0 dθ0 (1 − θ0 )V (K1 ) which shows that as the tax rate is increased. and decreasing (dT /dθ0 < 0) on (θ0 . we know that the bond price is P0 = 1. 6 11 . the tax revenue is known exactly (it is equal to T ).3 Optimal Transfer Under Certainty and No Default We analyze next the government’s decision starting ﬁrst with a simpliﬁed version of the general setup. we parameterize V with the functional form V (K1 ) = K1 . so that V (K1 ) = V (K1 ). Moreover. It can then be shown that: max Lemma 3. This calculation suggests that the continuation value implied by a multiperiod model should take a similar functional form. and then eventually decline. The tax revenue. is maximized at θ0 = 1 − γ. the second-order condition holds. the non-ﬁnancial sector reduces investment. In subsequent sections we remove these assumptions.

7 Under-Investment Loss Due to Taxes: The term dL/dT in (8) is the marginal underinvestment loss to the economy due to a marginal increase in expected tax revenue. which distorts the non-ﬁnancial sector’s incentive to invest. s0 ) ds0 = (1 − psolv ) dT ∂s0 dT0 dL dK1 =θ0 V (K1 ) dT dT which expresses the ﬁrst-order condition in terms of the choice of transfer size and expected tax revenue. For illustration. when the ﬁnancial sector is at high risk of insolvency and debt-overhang is signiﬁcant. 8 The curve shows that −L is convex as raising additional tax revenues incurs an increasingly large marginal (8) 12 . the marginal gain from increasing tax revenue (and hence the transfer) will be large when psolv is low. rather than in terms of the tax rate. then dL/dT < 0. Appendix A. we have that the transfer to the ﬁnancial sector is T0 = θ0 V (K1 ) − ND and there is no probability of default. and as the proof to Proposition 1 shows.4 shows that the ﬁrst-order condition for the government can be written as: dG dL + =0 dT dT where dG ∂f (K0 . For illustration. Since dK1 /dT < 0. ds0 /dT0 > 0. and we can consider the problem directly at t = 0. Equation (7) shows that it reﬂects the size of the tax-induced distortion. the government’s information regarding expected tax revenue is the same at t = 0 as at t = 1. Equations (5) and (6) show that it reﬂects the wedge between the social and private beneﬁts of an increase in ﬁnancial services. E[1def ] = 0. the graph of dG/dT is given by the solid curve in the top panel of Figure 2. which is greater than zero as long as the tax rate is positive. Since.Under the two simplifying assumptions. Gain From Increased Provision of Financial Services: The term dG/dT in (8) is the marginal gain to the economy of increasing expected tax revenue. Since there is no change in the non-ﬁnancial sector’s investment opportunities between t = 0 and t = 1. Hence. as shown above. a graph of −dL/dT is shown as the upward-sloping dashed curve in the top panel of Figure 2. G is concave in T since the marginal gain from increasing tax revenues (to increase the transfer) is decreasing. that is. As we explain below.8 7 As the graph indicates. this condition is intuitive since it equates the marginal gain and marginal loss of increasing tax revenue. the only choice variable for the government in this case is the tax rate.

this ˆ is at the intersection point of the two curves. 2. which is strictly less than θ0 . are increasing in the factor share of the ﬁnancial sector. The optimal tax rate and revenue are increasing in L1 . If also m ≤ 2. 2 (no default) and m ≥ 2ϑ. max The optimal tax rate is less than θ0 due to the Laﬀer-curve property of tax revenues. revenue. Then newly issued sovereign debt has face value ˆ NT = T − ND and a price of P0 = 1. then the optimal tax rate will be strictly greater than zero. 1.e. and newly issued sovereign debt. Therefore. max ˆ Proposition 1. since a lower probability of solvency increases the distortion in the provision of ﬁnancial services.5. For any level of transfer. in the top panel of Figure 2. the marginal gain available is greater the more severe is the debt-overhang. corresponding to the intersection point in the top panel. this marginal loss due to underinvestment worsens as T is increased. The face value of newly issued sovereign debt (the transfer) is increasing in the ﬁnancial sector liabilities L1 . then the optimal tax rate. psolv < 1).e.. by increasing tax revenue and outstanding debt. There is a unique optimal tax rate. the outstanding government debt.6. if there is any debt-overhang (i. since at a zero tax rate there is a marginal beneﬁt to having a transfer but no marginal cost. and in ND . Furthermore. The bottom panel of Figure 2 graphs the value of the government’s objective function. 13 . As the graph illustrates. Next. Moreover. is proven in Appendix A. the x-coordinate of which represents T . but decreasing in the amount of existing government debt ND . The optimal government action is to increase the transfer. T0 + kA ND . d2 L/dT 2 < 0. the ﬁnancial sector liabilities. is also decreasing in ND . Moreover.. consider the three parts of Proposition 1. whose slope is given by (8). θ0 . This represents an upward shift in the marginal gain curve. underinvestment loss. Let ˆ T represent the associated tax revenues. which describes the solution to the government’s problem under assumptions 1 (certainty).The Optimal Tax Rate and Issuance of Debt: The following proposition. the gross transfer. until the marginal gain from the transfer no longer exceeds the associated marginal loss due to underinvestment. In addition. 3. For illustration. the objective is concave in T and the unique ˆ optimum occurs at T . i. whereby the marginal underinvestment loss induced by raising revenue becomes inﬁnite as max the tax rate rises to θ0 . as shown in Appendix A.

but to hold total output constant while doing so. If the level of pre-existing government debt (ND ) is increased. Intuitively. and therefore the probability of solvency is lower. this pushes the government to increase the optimal tax rate. Hence. 9 10 NT = T − ND and 1def = 0 (No Default) Later. the ﬁnancial sector liabilities.9 Finally. however. Recall that the transfer T0 equals P0 NT . if the ﬁnancial sector’s output is a more important input into production.4 Default Under Certainty Now we allow the government to deviate from the no-default choice of setting NT = T − ND . The cost is that when NT > T − ND . As is clear from the new intersection point in the top panel.as (1) and (2) of Proposition 1 state.10 3. and as (1) of Proposition 1 states. more tax revenue. under the no-default and certainty assumptions. However. an increase in L1 . a larger factor share of the ﬁnancial sector in aggregate production implies that the government will issue a greater amount of new debt and a larger transfer. In that case. we may think about comparing the ratio to total output of our variable of interest while varying the factor share. then there will be a greater marginal gain from an increase in the provision of ﬁnancial services due to the transfer. we show that the possibility of default or the introduction of uncertainty can alter this result. ceteris paribus. an increase in pre-existing government debt corresponds to a decrease in newly issued sovereign debt and a smaller transfer T0 . splits the parameter space into two regions: 1. NT . triggering the dead-weight loss of D. the government’s decision on how many new bonds to issue. Equivalently. the eﬀective transfer (T0 ) is smaller. Hence. Note. that the comparative static is not simply to vary ϑ. 14 . The reason for this decrease is that the underinvestment cost of raising additional tax revenues is increasing. the government will not be able to fully cover its obligations. The factor share is given by ϑ. as (2) of Proposition 1 shows. The beneﬁt is that this can increase the transfer to the ﬁnancial sector. and greater issuance of new sovereign debt to fund a larger transfer. tax revenue. P0 < 1 and the government will default. T /(NT + ND )) is the price of the government bond. Proposition 1 shows that. leads to a higher tax rate. The reason is that for any level of tax revenue. Increasing NT above this threshold has both an associated cost and beneﬁt. and overall amount of sovereign debt. the rate of increase in total sovereign debt is less than the increase in ND . there is again an upward shift in the marginal gain curve. as shown by the dash-dot curve in the top panel of Figure 2. where P0 = max(1.

or shift the default-boundary itself. This implies that Wdef = Wno def N =0 − D. Formally. the amount of existing government debt ND . Wdef ). if the choice to default is made. and W = max(Wno def . ˆ ˆ Appendix A. We next consider the factors that push the sovereign towards default. Therefore. Ceteris paribus. let Wno def denote the maximum value of the government’s objective function conditional on no-default.4. and in the factor share of the ﬁnancial sector 2. and (3) equilibrium provision of ﬁnancial services is ˆ is bigger. s0 def > s0 no def . The following lemma characterizes the optimal government action and resulting equilibrium: Lemma 4. then it is optimal for the government to issue an inﬁnite amount of new debt in order to fully dilute existing debt (P0 becomes 0) and hence capture all tax revenues towards the transfer.7. T0 higher. Wdef denote the maximum value conditional on default. Conditional on default. the beneﬁt to defaulting is: 1. increasing in the ﬁnancial sector liabilities L1 (severity of debt-overhang).2. NT > T − ND and 1def = 1 (Default) As shown in Appendix A. The following proposition characterizes how a number of factors move the ‘location’ of the sovereign relative to the default-boundary. decreasing in the dead-weight default cost D.7 proves the lemma. Moreover. Proposition 2.1 Default Boundary Figure 3 displays the optimal default boundary in L1 × ND space along with the No-Default and Default regions. the gross transfer ˆ def > T0 no def + kA ND . if default is undertaken then (1) the D ˆdef ˆno ˆ optimal tax rate is lower. 3. to determine whether defaulting is optimal. The resulting situation is the same as if pre-existing debt ND had been set to zero. and in the fraction of existing government debt held by the ﬁnancial sector kA 15 . θ0 < θ0 def (2) provided that kA ND < T def . it is optimal to set NT → ∞ (and hence P0 → 0). the government evaluates whether its objective function for given ND and no default exceeds by at least D (the deadweight default cost) its objective function with ND set to zero.

decreasing the distance to the default-boundary. since the marginal gain of further transfer is higher at every level of transfer. causes collateral damage to the ﬁnancial sector balance sheet. 3. will have a ﬁnancial sector with a worse solvency situation.Appendix A. an increase in L1 ) leads to a large expansion in new debt (NT ) by the sovereign. as it acts to mitigate the under-provision of ﬁnancial services. Both the extra transfer and decreased underinvestment represent beneﬁts to defaulting. As the marginal cost of raising the tax revenue (dL/dT ) to fund this debt expansion is increasing.g. Consider a worsening of the ﬁnancial sector’s health.11 It is clear that an increase in the deadweight loss raises the threshold for default. A similar kind of result holds if the factor share of ﬁnancial services is increased. From the vantage point of Figure 3. Going in the other direction. both an increase in D and k cause an outwards shift in the default boundary. increases the gain to the sovereign from defaulting. a severe deterioration in the ﬁnancial sector’s probability of solvency (e. a ﬁnancial sector crisis pushes the sovereign towards distress.. This is represented by a move towards the right in Figure 3. This increases the marginal gain from further government transfer. since the marginal loss from funding extra debt is increasing. Hence. by Proposition 1.4.2 Two-way Feedback Propositions 1 and 2 indicate that there is a two-way feedback between the solvency situation of the ﬁnancial sector and of the sovereign. An increase in existing debt implies a bigger spread between the optimal transfer and optimal tax revenue with and without default. 16 . Hence. This is represented by a move upwards in Figure 3. as well as is its maximum debt capacity (lemma 3). and importantly. and.8 provides the proof.. this beneﬁt is convex in ND . Finally. by Proposition 1. which is aimed at freeing up resources towards the transfer. e. the sovereign is pushed closer to the decision to default (Proposition 2). one with high existing debt (ND ). a distressed sovereign. This is because it is very costly for such a sovereign to fund increased debt to make the transfer to the ﬁnancial sector. in turn. leading to a decreased provision of ﬁnancial services. If the sovereign has a lot to lose from defaulting (think a sovereign with strong domestic credibility or international reputation) then the net beneﬁt to default will be relatively lower.g. an increase in the fraction of existing sovereign debt held by the ﬁnancial sector also raises the threshold for default since the act of defaulting. First. a more distressed sovereign will tend to correspond to a more 11 Moreover. again decreasing the distance to the default-boundary.

the expected tax revenue. Hence. and Pricing We now introduce uncertainty about future output (i.distressed ﬁnancial sector (lower post-transfer psolv ). leading to a ‘spillover’ of the ﬁnancial sector crisis onto the solvency of the sovereign. Instead of a binary default vs.5 Uncertainty. In this case. are the variables the government directly chooses. However.e. The ﬁrst variable is T .. Default. it will turn out to be more enlightening to look at two other variables that map to them in a one-to-one fashion. the mapping from H to NT is invertible. these alternative control variables map uniquely to the original ones on the region of interest. if raising taxes further incurs a large under-investment loss. no-default decision. limiting the beneﬁt from this option (Proposition 2). the government can choose to increase debt issuance while holding the tax rate constant. large holdings of sovereign debt (k) by the ﬁnancial sector means that taking this avenue simultaneously causes collateral damage to the balance sheet of the ﬁnancial sector. respectively. The government’s problem (3) then is equivalent to optimally choosing T and H. The trade-oﬀ is an increase in the government’s probability of default and expected dead-weight default loss. In this case. This dilutes the claim of existing bondholders to tax revenues. Strategically defaulting is an avenue for a distressed sovereign to free debt capacity for additional transfer. where RV ≥ 0 represents the ˜ ˜ ˜ shock to V (K1 ). We also assume that the distribution of RV max Formally. In this case. a distressed sovereign is further incapacitated in its ability to strengthen the solvency of its ﬁnancial sector. 12 17 . the mapping from θ0 to T is invertible on [0. 3. By construction. thereby generating a larger transfer without inducing further underinvestment. Although θ0 and NT .12 Note that the no-default and total-default cases under certainty correspond to setting H = 1 and H → ∞. The second variable is: H= NT + ND T In words. It measures the sovereign’s ability to cover its total debt at face value. E[RV ] = 1. H is the ratio of outstanding debt to expected tax revenue. θ0 ] (as before. which again equals θ0 V (K1 ). the government now implicitly chooses a continuous probability of default when it sets the tax rate and new debt-issuance. the sovereign eﬀectively ‘sacriﬁces’ its own creditworthiness to improve the solvency of the ﬁnancial sector. we can limit our concern to this region) and given T . ˜ ˜ ˜ To represent uncertainty we write V (K1 ) = V (K1 )RV . growth) by allowing the variance ˜ of V (K1 ) to be nonzero.

and as proven in Appendix A. as H increases. this cost is a ﬂat function of H until the upper end of the support of the distribution. increasing H while holding T constant increases the transfer. This captures a greater faction of tax revenues towards the transfer but raises the probability of default. respectively. The top panel of Figure 4 illustrates the marginal gain (solid line) and loss (dashed line) incurred by increasing H for a ﬁxed level of T . ˜ θ0 V (K1 ) NT + ND = E0 min 1. As (9)–(11) show. The ﬁrst-order condition for T involves the same transfer-underinvestment trade-oﬀ as under certainty. For ˜ RV uniformly distributed. Figure 4 indicates that (with T held constant) there are two potential candidates for the 18 . To generate the plots. Raising H beyond this point represents sure default (pdef = 1). and NT .is independent of the variables K1 . raising H increases the transfer by diluting existing bondholders–it raises outstanding debt but without increasing expected tax revenue. pdef . we need ˜ to assume a speciﬁc distribution for uncertainty. but also increases the probability of sovereign default and decreases the sovereign bond price. The dash-dot line represents the marginal gain curve at a higher level of L1 than for the solid line. falling to zero beyond this upper point. Varying H involves a new trade-oﬀ. as NT = (T − ND /H)H. and probability of default. Pricing. = 1 ˜ RV H (9) (10) ˜ = prob θ0 V (K1 ) < NT + ND ˜ prob RV < H Note that these quantities depend only on H and do not directly change with T . This is shown by the dashed green line in Figure 4. Default Probability and the Transfer: Using H we can easily express the sovereign’s bond price. Next. RV H (11) The Optimal Probability of Default: Appendix A. As the ﬁgure shows. P0 . For simplicity. the marginal gain curve is downwards sloping. The marginal cost of an increase in H is the rise in expected dead-weight default cost.10 derive the ﬁrst-order conditions for T and H.9 and A.10. θ0 . we express the transfer in terms of T and H: T0 = NT P0 = (T − ND ˜ )E0 min H. we let RV have a uniform distribution.This is because. the marginal increase in the transfer due to further dilution decreases. as follows: P0 pdef = E0 min 1. adjusted to account for H. Intuitively.

it is optimal for the government to fully dilute existing bondholders to obtain the largest possible transfer. the objective function again rises in H. the government will optimally begin to ‘sacriﬁce’ its own creditworthiness to generate additional transfer. H) is an interior solution to the government’s problem on a region ˆ of the parameter space. Th reason for this is that. and decreasing in ˆ D. T is also increasing in L1 . a high L1 (i. the government’s optimal choices of H and T in equilibrium: ˆ ˆ Proposition 3. If (T . a ﬁnancial sector crises) will be associated with both a high T and a high level of H. The second is to let H → ∞. it pushes down the curve because it lowers overall welfare. it corresponds to an optimal non-zero probability of default. Therefore. 3. In the bottom panel. once debt issuance is large enough that default is certain. This comes at the cost to the sovereign of a further increase in the probability of default. The bottom panel of Figure 4 plots the corresponding value of the government’s objective as a function of H. in ND and in ϑ.5. Furthermore. 19 . The plot shows that for the conﬁguration displayed. As this optimal H is beyond the left end of the support of RV (which is the origin in the ﬁgure).1 Comparative Statics Under Uncertainty The government jointly chooses T and H in an optimal way by comparing the relative marginal cost and beneﬁt of adjusting each quantity. it would become optimal for a suﬃciently high level of L1 .optimal choice of H. The ﬁrst is the value of H at which the gain and loss curves intersect. the dash-dot curves in Figure 4 correspond to an increase in L1 (more severe debt-overhang) relative to the solid lines.. As is apparent in the top panel. When the marginal beneﬁt of additional transfer is large. up to the point where total default becomes optimal. representing a total default and full dilution of existing bondholders. As indicated. The ˆ ˆ following proposition characterizes how diﬀerent factors impact H and T . but the marginal underinvestment loss due to taxation is already high. From the bottom panel it is apparent that while total default is still suboptimal. which is at the intersection of the gain and loss curves ˜ in the top panel.e. pushing up the marginal gain curve in the top panel. then H is increasing in L1 . this worsening of ﬁnancial sector solvency increases the marginal gain from an increase in H. Finally. the optimal response of the sovereign is to increase the optimal H (by issuing more debt) in order to increase the transfer. a relatively small value of H achieves the optimum. Note ˜ that beyond the upper end of the support of RV .

For simplicity. freeing extra capacity for the sovereign to generate the transfer. We then plot in Figure 5 comparative statics of the equilibrium (optimal) values of T . Correspondingly. the underinvestment costs of increasing tax revenue becomes very high and again the sovereign begins to increase H to fund the transfer. the optimal government response can be a total default. P0 remains fully valued at 1. the dilution of existing bondholders is an eﬀective channel for increasing the transfer. which begins to decrease once H begins to rise. at high enough ND . so the probability of sovereign default remains 0. the plot shows that in this range. P0 drops to 0. The plots also show that. the government chooses to increase H. The top panel of Figure 5 is for L1 . For low levels of L1 . The outcome of a total default is illustrated in the plots at the point of the dotted line. H is held constant at a low value. This occurs because higher H means a a greater proportion of expected tax revenue is captured towards the transfer 13 20 . Once ND is suﬃciently high. At the same time. As indicated in the plots. Moreover.13 . total default becomes optimal. Note that the transfer increases more rapidly in L1 once H begins to increase. similar to the case of certainty. so there is no probability of default and P0 remains at 1. As in the certainty case. It is apparent that for low levels of debt the sovereign keeps H constant at the low end of its support. ﬁnancial crisis). up to the point where the sovereign chooses total default. ˜ we again let RV have a uniform distribution. as shown in the plot. the probability of default rises and P0 begins to decrease. The reason for this is that for large ND .˜ To obtain more precise results we choose a speciﬁc distribution for RV . T0 . as indicated by the dotted lines. while the damage to the sovereign’s creditworthiness is apparent in the plot for P0 . This value ˜ corresponds to the lower end of the support of RV . The discontinuities that appears in the plots. H. As discussed above. Consequently. as the plots show. The bottom panel of Figure 5 shows the comparative statics for ND . For these values of ND . The increase in the transfer is apparent in the subplot for T0 . total default fully dilutes existing bondholders. in this range the combination of increased H and T imply that the transfer is actually increasing in ND . Note that in this range the transfer is decreasing in ND . represent the point at which total default becomes optimal. when the ﬁnancial sector’s situation is severe enough (L1 is large)..g. and P0 as L1 and ND are varied. Interestingly. For suﬃciently high L1 (e. The corresponding plot for H tells a diﬀerent story. this leads to a jump up in T0 and a jump down in T . the government funds the transfer exclusively through increases in tax revenues. it ‘sacriﬁces’ its own creditworthiness in order to achieve a larger transfer. It shows that T increases monotonically in L1 .

That is.6. In the interest of simplicity. Second. and since debt-overhang alleviation is the central feature of bailouts in the model. we add to the model a simple notion of a government guarantee of ﬁnancial sector debt. We model debtholders as potentially liquidating (or inducing a run on) the ﬁnancial sector if they are required to incur losses in case of ﬁnancial sector default. the government ‘guarantees’ their debt. it has been common for sovereigns to step in to prevent the liquidation of banks by guaranteeing their debt. the ‘guarantee’ is just equivalent to a claim that issues L1 − A1 − T0 new government bonds to debtholders in case of insolvency. To prevent debtholders from liquidating. ˜ In fact. This The fallout from the failure of Lehman brothers and the apparent desire to prevent a repeat of this experience has strongly reinforced this view 14 21 . This unique feature is important in helping us identify empirically a main implication of our model.3. We do this for two reasons. which is necessary pre-condition for the sovereign to act to alleviate debt-overhang and increase the provision of ﬁnancial services. the ‘guarantee’ has the same credit risk as other claims on the sovereign. 3.6 Government ‘Guarantees’ Government guarantees of ﬁnancial sector debt have been an explicit part of a number of countries’ ﬁnancial sector bailouts. that there is direct feedback between sovereign and ﬁnancial sector credit risk. Instead. In this section. we do not explore the feedback of the guarantees on the transfer and taxation decisions analyzed above.1 Avoiding Liquidation A precursor to the government’s actions to increase the provision of ﬁnancial services is to prevent liquidation of the ﬁnancial sector. This ‘guarantee’ is pari-passu with other claims on tax revenue. their beneﬁt is targeted at debtholders and not equity holders. Hence. which strongly suggests that there is an implicit ‘safety net’. we simply set the stage for the implications of the guarantees for our empirical strategy. it pledges to bondholders ˜ L1 − A1 − T0 from tax revenues in case of insolvency. notably Ireland. by construction. Moreover. First. guarantees are a measure that serves to prevent liquidation of the ﬁnancial sector by debtholders. 14 . Note that this claim accrues exclusively to debtholders and not to equityholders. guarantees are rather unique in that.

Importantly. The following proposition gives a formal statement of this. Let D be the value of debt. to maintain simplicity we will not incorporate the impact of the guarantee on the government’s optimal choice of tax revenue or debt issuance.15 3. In the presence of a guarantee. derived under a ˜ uniform distribution for A1 (same as used above to generate the ﬁgures). the return on equity is suﬃcient for knowing the return on debt. This corresponds to the canonical model of debt. E the value of equity. 22 . such as the asset paying A1 or the transfer. the return on debt is a bivariate function of both the return on equity and the return on the sovereign bond price.6. This implies that.2 Two-way Feedback As illustrated by Proposition 3 and the discussion of Figure 5. is concentrated primarily with debt. following Merton (1974). where changes in the total value of the ﬁrm are reﬂected in both debt and equity values. (1 − psolv )(1 − P0 ) E dE (1 − psolv )2 L1 P0 dP0 dD ≈ + D psolv D E 2 D P0 (12) The term involving the equity return captures the impact on the debt value of any changes in the value of the general pool of assets of the ﬁrm. in the presence of a guarantee. the change in equity value will not be suﬃcient for determining the change in debt value. Instead. including expected future proﬁts of the ﬁrm. This is because the guarantee represents additional (state-contingent) debt issuance by the sovereign. a severe ﬁnancial sector crisis ‘spills over’ onto the sovereign via an increase in H and deterioration of the sovereign’s 15 Note that there is theoretically also an indirect feedback of sovereign credit risk on ﬁnancial sector credit risk. In the absence of a guarantee. T0 . there is the additional second component. This bivariate dependence is approximated by the following relation. while a change in the value of the guarantee changes the value of debt but not the value of equity. It is therefore not captured adequately by the return on equity and requires the second term. which picks up the change in the value of debt coming from changes in the value of the government guarantee. if there are guarantees. In contrast. which is derived in the Appendix. which raises expected default costs of the sovereign and potentially reduces the size of the transfer to the ﬁnancial sector. ˜ Proposition 4. The change in value of the guarantee. which reﬂects variation in the credit risk of the sovereign. As mentioned above. a change in the value of general assets of the ﬁrm changes the value of equity and debt in a certain proportion.˜ diﬀerentiates it from general assets of the ﬁnancial sector. and A1 be distributed uniformly. we will mainly use the above result to motivate some of our empirical work.

creditworthiness. and a signiﬁcant loss in the market value of their equity. furthermore. as the bottom panel of Figure 5 shows. which culminated in Lehman Brother’s bankruptcy. The pre-bailout period.g. an additional important consequence of increased H that can be seen from the model with uncertainty. In addition. there is an upper value where total default becomes optimal. With the introduction of uncertainty about realized tax revenues. saw a severe deterioration in banks’ balance sheets. post-transfer. growth). Moreover. the increase in H varies continuously with the severity of the ﬁnancial sector crisis (L1 ) and is reﬂected continuously in the price of the sovereign’s bonds (equivalently. around. We interpret this as setting the stage for the initial time 23 . ceteris paribus. as we have shown. Once H is increased. then any resulting decrease in the sovereign’s bond price due to increasing H causes collateral damage to the ﬁnancial sector’s balance sheet. This decreases the net transfer to the ﬁnancial sector. in CDS levels). not only does the probability of default increase. a weaker post-transfer ﬁnancial sector (lower post-transfer psolv ). there will be increased co-movement between the likelihood of sovereign and ﬁnancial sector solvency. This negative shock generated substantial debt overhang in the ﬁnancial sector and signiﬁcantly increased the likelihood of failure of. or runs on. There is. ﬁnancial institutions. but so does the sensitivity of the bond’s ﬁnal payoﬀ to realized growth (and hence tax revenue) shocks. higher pre-existing sovereign debt is associated with lower post-transfer sovereign bond prices. the increase in H will make the ﬁ˜ nancial sector more sensitive to shocks to RV (e. leaving it less well-oﬀ post transfer. Moreover. Since the ﬁnancial sector’s solvency post-transfer is dependent on this payoﬀ due to its holdings of transfer and pre-existing government bonds. Going in the other direction. and after. if the ﬁnancial sector has substantial holdings of existing sovereign bonds (substantial kA ). 4 Empirics In this section we present empirical evidence in favor of the main arguments made by this paper: (1) the bailouts reduced ﬁnancial sector credit risk but were a key factor in triggering the rise in sovereign credit risk of the developed countries and (2) there is a two-way feedback between the creditworthiness of the sovereign and the ﬁnancial sector. This implies that. The setting for our empirical analysis is the ﬁnancial crisis of 2007-10. higher pre-existing debt corresponds to a smaller transfer and therefore. We divide the crisis into three separate periods relative to the bailouts: pre.. a substantial rise in the credit risk of ﬁnancial ﬁrms.

and Australia with more than $50 billion in assets as of the end of ﬁscal year 2006. the United States. A signiﬁcant challenge in demonstrating direct sovereign-bank feedback is the concern that another (unobserved) factor directly aﬀects both bank and sovereign credit risk. we search for investment grade credit ratings using S&P Ratings Express. We choose this sample because smaller banks and banks outside these countries usually do not have traded CDS. We ﬁnd CDS prices for 99 banks and match CDS prices to bank characteristics from Bankscope. giving rise to co-movement between them even in the absence of any direct feedback. 4. This is followed by the two sections of detailed results and the evidence based on the European bank stress test data. per the model. We address these concerns by utilizing a particularly useful feature of government ‘guarantees’–that they are targeted speciﬁcally at bank debt holders–to control for changes in bank fundamentals. The second part of our analysis focuses on point (2) by testing for the sovereign-bank two-way feedback. We also gather and exploit data on the sovereign bond holdings of European banks that was released after the stress tests conducted in the ﬁrst half of 2010. This relationship is predicted by the model and is supportive of argument that the bailouts induced increases in sovereign credit risk. The ﬁrst part focuses on point (1). We ﬁnd credit 24 . We presents evidence that the bailouts transmitted risk from the banks to the sovereigns and triggered a rise in sovereign credit risk across a broad cross-section of developed countries. We also analyze the ability of the pre-bailout credit risk of the ﬁnancial sector and prebailout government debt-to-gdp ratio to predict post-bailout credit risk.period in the model. and the bank bailouts as the sovereign’s response. Next. We then conﬁrm a prediction of the model by documenting the emergence post-bailout of a positive relationship between sovereign credit risk and government debt-to-gdp ratios. We then search for CDS prices in the database Datastream. Using this data we show that banks’ holdings of foreign sovereign bonds has information about how foreign sovereign credit risk aﬀects a bank’s credit risk. We next describe the data construction and provide some summary statistics.1 Data and Summary Statistics We use Bankscope to identify all banks headquartered in Western Europe. We make extensive use of a broad panel of bank and sovereign CDS data to carry out tests that establish this channel and show that it is quantitatively important. We present our empirical results in two parts.

1 and 90. 4. 2008. As of July 2007. we match these data to sovereign CDS of bank headquarters and OECD Economic data on public debt.5%. the increase in bank credit risk was triggered by the Lehman bankruptcy. some of the ﬁnancial sector risk was transferred to sovereigns. respectively. We note that bank equity values declined sharply during this period with a negative weekly return of 7. 2008 in Ireland.4%. This evidence suggests the emergence of signiﬁcant sovereign credit risk after the bank bailouts.6 basis points.1% and the average Tier 1 ratio was 8. average bank and sovereign CDS were 194.3 billion and equity of $26.2 The Sovereign Risk Trigger The ﬁrst bank bailout announcement in Western Europe was on September 30. Panel B of Table 1 present summary statistics of weekly changes in bank CDS and sovereign CDS for the main bailout periods. the average bank had assets of $589. We start it in March 2007. Before the bank bailouts. This low level of sovereign credit risk suggests that ﬁnancial market participants did not anticipate large-scale bank bailouts prior to September 2008. This level of bank credit risk reﬂected primarily banks’ exposure to subprime mortgages and related assets. In the bailout period.8 basis points and the average sovereign CDS (if available as of July 2007) was 6. As a result of the bailouts. All results presented below are robust to including these observations. After Lehman. We also ﬁnd signiﬁcant variation in sovereign CDS with a standard deviation of weekly changes of 12. These CDS levels are suggestive of a signiﬁcant transfer of ﬁnancial sector credit risk on sovereign balance sheets.1 basis points. we see a signiﬁcant rise in both bank and credit risk with average bank and sovereign CDS of 301. respectively.2 basis points. Finally. The average bank CDS was 21.8 basis points. As we discuss below.8 billion. The average sovereign CDS was 12. In the post-bailout period. which increased average sovereign credit risk. most governments announced bank bailouts aimed at reducing bank credit risk. prior to the start of the ﬁnancial crisis.9%.3 and 33. Note that this period 25 . The average equity ratio was 5. Therefore we deﬁne the pre-bailout period as ending on September 29. Panel A of Table 1 presents summary statistics for all banks with CDS prices and investment grade credit ratings. We drop all observations with zero changes in bank CDS or sovereign CDS to avoid stale data. the average bank CDS was 98.ratings for 86 banks and match these data to CDS prices and bank characteristics.6 basis points.

the pre-bailout period captures both the prolonged increase in bank credit risk during 2007-2008 and the post-Lehman spike that occurs before the bank bailouts. they can explain the small rise in sovereign CDS that occurs late in the pre-bailout period. We compute the change in sovereign CDS and bank CDS during this period for all countries in our data set. Hence. the fact that the impact in this period is so small quantitatively suggest that the bank bailouts were a surprise to the majority of investors. so that it includes the immediate eﬀect of Lehman’s bankruptcy on other banks prior to the Ireland announcement. 2008. the average bank CDS in Ireland increases by 300 basis points over this period. Figure 6 summarizes the results for the pre-bailout period. there is almost no change in sovereign CDS. However. 2010. The ﬁgure shows that there is a large increase in banks CDS prior to the bank bailouts. Most bank support programs consisted of asset purchase programs. the ﬁgure shows that the credit risk of the ﬁnancial sector was greatly increased over the pre-bailout period but that there was little impact on sovereign credit risk. Several countries made more than one announcement during this period. However. 2008. the ﬁrst column depicts the change in sovereign CDS and the second column depicts the change in bank CDS over the pre-bailout period. As a result. the bank bailout announcements were not truly independent since sovereigns partly reacted to other sovereigns’ announcements. For each country we compute the change in bank CDS as the unweighted average of all the banks with CDS prices. bank CDS signiﬁcantly decreased over this one-month period. debt guarantees. Almost every Western European country announced a bank support program in October 2008. 2008. in part to oﬀset outﬂows from their own ﬁnancial sectors to newly secured ﬁnancial sectors. the ﬁrst country to make a formal announcement was Ireland on September 30. For each country. Figure 7 plots the average change in bank CDS and sovereign CDS over the bailouts period. As noted above. We therefore deﬁne the around-bailouts period as the period in which the bank bailout announcements occurred.includes the bankruptcy of Lehman Brothers on September 15. To the extent that investors held such expectations prior to September 30. As shown in the ﬁgure. and equity injections or some combination therefore. but also the period immediately afterwards. 26 . Many other countries soon followed Ireland’s example. Such an expectation would reduce the observed increase in bank CDS and shift forward in time the rise in sovereign CDS. We note that some investors may have expected bank bailouts even before the ﬁrst oﬃcial announcement on September 30. For example. We omit countries for which either sovereign CDS or banks CDS are not available. Overall.

it is clear that bank CDS and sovereign CDS move together after the bank bailouts. It shows that the sovereigns responded to the distress in the ﬁnancial sector with the bailouts. However.For example. The results are robust to using other cut-oﬀ dates in 2010. At the same time. Indeed the ﬁgures clearly show that these sharp increases were aligned tightly with the bailout announcement period. Figure 8 plots the change in bank CDS and sovereign CDS over this post-bailout period. Table 2 presents the result of our analysis. There is a clear. For example. It shows that both sovereign CDS and bank CDS increased across all countries. the sovereign CDS of Ireland increased by about 50 basis points. We measure the government debt-to-gdp ratio as the government gross liabilities as a percentage of gdp. 2010. the reporting date for the European bank stress tests. the average bank CDS in Ireland decreased by about 200 basis points. immediate increase in the sovereigns’ credit risk. This suggests that they are tied together and feedback on each other as our model suggests. Moreover. especially ones that had a large increase over the pre-bailout period. most other countries had a signiﬁcant decrease in bank CDS. For the postbailout date we choose March 31. 2008. and government debt-to-gdp ratios. in accordance with our model. there is a signiﬁcant increase in sovereign CDS. The appearance of this striking pattern across a broad cross-section of countries is directly in line with the predictions of our model. We choose March 2010 because this is the date for which the European bank stress data results were released. Similarly. Moreover. We measure pre-bailout ﬁnancial sector distress at the country level by averaging bank CDS on September 22. Column (3) shows the result from regressing post-bailout log sovereign CDS on post-bailout debt-to-gdp. this caused a contemporaneous. positive 27 . Our model predicts that the bailouts should lead to an increase in sovereign credit risk and that the post-bailout level of credit risk should depend on pre-bailout debt and the pre-bailout level of ﬁnancial sector distress. Most other countries exhibit a similar pattern with decreasing bank CDS and increasing sovereign CDS. the model suggests that there should emerge after the bailouts a positive relationship between measures of government debt-to-gdp even if such relationship appears before. We deﬁne the post-bailout period as beginning after the end of the bank bailouts and ending in March 2010. achieving a substantial reduction in banks’ credit risk. ﬁnancial sector distress. We choose this date midway between Lehman’s bankruptcy and the ﬁrst bailout announcement. We test these predictions using data on sovereign CDS.

From the point of model. Note. Column (3) shows that the coeﬃcient on ﬁnancial sector distress in the pre-bailout period is also statistically insigniﬁcant. Columns (5) examines the ability of pre-bailout ﬁnancial sector distress to predict the change in government debt-to-gdp from the pre-bailout to the post-bailout period. The coeﬃcient on debt-to-gdp decreases slightly but remains marginally signiﬁcant. whereas debt-to-gdp ratios are lagging. In contrast. that the emergence of this relationship coincides with an overall rise in sovereign debt ratios. We can address this to some extent by using leading debt-to-gdp. This is displayed in the upper panel of Figure 9. the model predicts that H determines the level of sovereign CDS. debtto-gdp ratios are an imperfect proxy for θ0 H because H takes into account any future issuance of debt to pay for current obligations related to the bailouts. The R-squared of the regression is close to 50%. Column (4) shows the result when the log of the pre-bailout ﬁnancial distress variable is also added as a dependent variable. First. From these results we can see that there emerged a relationship between debt-to-gdp and sovereign credit risk that was not present beforehand. Consistent with the model. The coeﬃcient is small and is statistically insigniﬁcant. we ﬁnd that ﬁnancial sector distress is positively related to the increase in debt-to-gdp.relationship and the coeﬃcient is statistically signiﬁcant. Both coeﬃcients are statistically signiﬁcant and together the two variables explain 84% of the variation in post-bailout debt-to-gdp. the debt-to-gdp ratio corresponds to θ0 H in the model rather than simply H. As Column (4) shows the coeﬃcient on pre-bailout ﬁnancial distress is large and highly statistically signiﬁcant. 4. post-bailout debt-to-gdp is predicted by pre-bailout debt-to-gdp and pre-bailout ﬁnancial sector distress.965%. the prediction of the model carries over to θ0 H since θ0 is increasing in ﬁnancial sector distress.16 This relationship is shown in the bottom panel of Figure 9. Column (1) of Table 2 shows that in the pre-bailout period there is only a very weak relationship between debt-to-gdp and sovereign CDS. the sovereigns have increased debt-ratios into the region where dilution occurs and there is a negative relationship between debt-ratio and price (see Figure 5). the price of its debt We make note of two points. Nevertheless. The coeﬃcient is positive and marginally statistically signiﬁcant. However. 16 28 .3 The Sovereign-Bank Feedback In this section we analyze the two-way feedback between sovereign and bank sector credit risk. The coeﬃcient shows that a 1% increase in pre-bailout ﬁnancial sector distress increases postbailout sovereign CDS by 0. Second. Once the sovereign opens itself up to credit risk due to bailouts. Column (6) shows that consistent with the model’s predictions. moreover.

Our market-wide controls are a CDS-market index and a measure of aggregate volatility. Such a factor would explain their co-movement without there necessarily being an underlying direct channel between them. 17 29 . we interpret changes in sovereign credit risk as changes in expectations about macroeconomic fundamentals. the estimate of β is 0. Hence. At the weekly frequency. Our model indicates that subsequent changes in the sovereign’s credit risk should impact the ﬁnancial sector’s credit risk through three channels: (i) ongoing bailout payments and subsidies. from the sovereign to the ﬁnancial sector. We take a number of steps to address this concern. In the ﬁrst step. the sovereign’s creditworthiness is important in determining the potential for and magnitude of future bailout steps. and productivity. This result shows that sovereign and bank CDS exhibit a strong comovement and is consistent with direct sovereign-bank feedback. This may occur when early eﬀorts are deemed to be insuﬃcient. More speciﬁcally. which is comprised of 125 of the most liquid While we model the bailout as happening in one stage. we add controls that capture market-wide changes that aﬀect both bank and sovereign risk directly. Our CDS market index is the iTraxx Europe index. This leads a second direction of feedback. an obvious concern is that there is another (unobserved) factor that aﬀects both bank and sovereign credit risk. This presents another. such as employment. (iii) explicit and implicit government guarantees. The feedback channels imply that we should ﬁnd that changes in sovereign and bank credit risk are positively correlated.47 and is highly statistically signﬁcant. growth. We start by estimating the following relationship in the post-bailout period: ∆ log(Bank CDSijt ) = α + β∆ log(Sovereign CDSjt ) + εijt where ∆ log(Bank CDSijt ) is the change in the log CDS of bank i headquartered in country j from time t to time t − 1 and ∆ log(Sovereign CDSjt ) is the change in the log Sovereign CDS of country j from time t to time t − 1.becomes sensitive to macroeconomic shocks. This means that a 10% increase in sovereign CDS is associated with a 4. changes in macroeconomic conditions may generate a correlation between sovereign and bank credit risk even in the absence of direct feedback.17 (ii) direct holdings of government debt. dynamic channel through which changes in sovereign creditworthiness impact both ﬁnancial sector debt and equity values. As with the one-stage bailout in our model.7% increase in bank CDS. However. establishing that there is indeed direct feedback between sovereign and ﬁnancial sector credit risk is a signiﬁcant challenge. in practice bailouts may occur in mutliple steps. Therefore. These fundamentals also have a direct eﬀect on the value of bank assets such as mortgages or bank loans.

This captures changes in aggregate volatility which is an important factor in the pricing of credit risk. Column (8) adds the weekly ﬁxed eﬀects. and CDS-market speciﬁc shocks. the ﬁxed eﬀect captures any variation that is common across all banks. as expected. They therefore conclude that this variation represents ‘local supply/demand shocks’ in the corporate bond market. Goldstein. implying that an independent increase in sovereign CDS of 10% translates into a 1. The coeﬃcient on sovereign CDS decreases but remains highly statistically signiﬁcant.63% increase in bank CDS. so we examine the postbailout results ﬁrst. the VDAX. Note that the weekly ﬁxed eﬀects are collinear with the market-wide control variables. and post-bailout periods. In the third step. which is the DAX-counterpart to the VIX index for the S&P 500.18 For the volatility index we follow the empirical literature and use a VIX-like index. The magnitude is also economically important. The CDS market index captures market-wide variation in CDS rates caused by changes in fundamental credit-risk. Therefore. the coeﬃcient on CDS market is large. liquidity. δt are the weekly ﬁxed eﬀects. The right column adds the bank-speciﬁc coeﬃcients on the controls and bank ﬁxed eﬀects. The left column reports the coeﬃcient estimates including the market-wide control variables. The decrease is not surprising. as time ﬁxed eﬀects represent a very rich set of controls. In the second step.CDS names referencing European investment grade credits. around. The middle column adds the weekly ﬁxed eﬀects. We implement this approach by estimating the following regression: ∆ log(Bank CDSijt ) = αi + δt + β∆ log(Sovereign CDSjt ) + γ∆Xijt + εijt where ∆Xijt are the changes in the control variables from time t to time t − 1. Altogether. and Martin (2001) ﬁnd that a substantial part of the variation in corporate credit spread changes is driven by a single factor that is independent of changes in risk factors or measures of liquidity. and highly statistically signiﬁcant. As would be expected. This accommodates potential non-linearities in relationships. For each week. The control coeﬃcients are both statistically signiﬁcant and the signs are as expected. and the αi are bank ﬁxed-eﬀects Table 3 shows the results for the pre. an increase in aggregate CDS levels or volatility is associated with a rise in banks’ CDS. For each period there are three columns of results. Column (7) shows that β is positive. we include bank-speciﬁc coeﬃcients on all the control variables and bank ﬁxed eﬀects. we do not estimate coeﬃcients on the market-wide Collin-Dufresne.6% of the variation in weekly bank CDS. Our main focus is on testing for the sovereign-bank feedback. the variables explain 31. 18 30 . we include weekly ﬁxed eﬀects.

Column (9) shows that the coeﬃcient on sovereign CDS is essentially unchanged and remains highly statistically signiﬁcant after adding bank-speciﬁc coeﬃcients on the control variables .1 Controlling for Bank Fundamentals The results above establish that there is a strong sovereign-bank feedback. the CDS market control coeﬃcient is signiﬁcant and has a large magnitude. 4.controls. a negative macroeconomic shock will decrease the value of banks’ assets or future earnings power. Therefore. in the pre-bailout period there is no evidence for sovereign-bank feedback. it is evidence that in fact sovereigns that took on more credit risk.3. Hence. This will raise bank and sovereign CDS even in the absence of a direct feedback between them. We address this concern using a strategy that utilizes a particularly useful feature of government ‘guarantees’–they are targeted speciﬁcally at bank debt holders. there may remain a concern that our strategy to this point does not control for country-speciﬁc macroeconomic shocks that bank-level fundamentals. Columns (1)-(3) show the results for the pre-bailout period. and hence saw a greater increase in their CDS. while at the same time reducing national output. in the around-bailout period an independent increase in sovereign CDS is associated with a decrease in bank CDS. Given the ﬂexibility of this speciﬁcation we interpret the survival of the coeﬃcient on sovereign CDS as robust evidence in favor of direct sovereign-bank feedback. Perhaps due to the short time-series. This implies that sovereign-speciﬁc shocks should have a disproportionate impact on debt holders because. However. For example. Comparing these results with those for the around-bailout period in columns (4)-(6) shows interesting diﬀerences. More precisely. They show a small coeﬃcient on sovereign CDS that is indistinguishable from 0. When the panel is estimated at the daily frequency they do in fact come up signiﬁcant (unreported). similar to the results for the other periods. decreased by a greater amount their banks’ CDS. the coeﬃcient on sovereign CDS is negative. In other words. to establish whether there is a direct channel 31 . indicating that most of the variation was already captured by the market-wide controls. For the around-bailout period. In contrast. such shocks change the value of government ‘guarantees’ (implicit or explicit). the coeﬃcients are only marginally signiﬁcant. This shock may not be fully captured by our market-wide controls if it has a heterogenous impact across countries. This is very much consistent with the evidence presented above that the sovereigns took onto themselves credit risk from their ﬁnancial sectors during this phase. in addition to changing the value of bank assets. There is an increase in the R-squared ofabout 7% over column (7).

Proposition 4 shows that bank equity returns are suﬃcient for determining changes in bank CDS in the absence of government ‘guarantees’. Our strategy for dealing with this concern is motivated by the model. To this end. Columns (7)-(9) show that in the post-bailout period we ﬁnd that the coeﬃcient on sovereign CDS survives and is highly statistically signiﬁcant. making it diﬃcult to document their existence. It holds in models of defaultable bond pricing that build on the canonical model of Merton (1974). where stock returns contain all information about changes in bank asset values and therefore can (locally) capture all variation in the price of debt. The structure is similar to Table 3. The results show that the coeﬃcient on sovereign CDS decreases somewhat but remains highly signiﬁcant.2 Bank-level Heterogeneity To analyze further sovereign-bank feedback we also examine whether heterogeneity in bank characteristics aﬀects banks’ sensitivity to changes in sovereign CDS. we estimate the coeﬃcient on an interaction term of changes in sovereign CDS and a bank’s Tier 1 capital ratio. Indeed. As shown in columns (7) and (8). In the presence of ‘guarantees’. As shown in columns (1) to (6). On the other hand. a-priori it seems that even if there are direct sovereign-tobank channels. Column (9) includes bank-speciﬁc coeﬃcients on bank stock returns. a regression that controls for equity returns should still ﬁnd a (negative) beta on changes in sovereign CDS. 19 32 . The Tier 1 capital ratio is commonly used in the banking industry as a proxy for a This result is in fact quite general. We therefore augment the regression with banks’ weekly equity returns.we can test if sovereign CDS is still a determinant of bank CDS after we control for the impact of shocks to bank fundamentals. For the bailout and pre-bailout periods. Proposition 4 shows that ‘guarantees’ present a source for such a potential ﬁnding because they discriminate precisely in favor of debtholders. although the bank stock return coeﬃcient is highly statistically signiﬁcant and possesses the expected negative sign.19 This implies that once we control for bank equity returns we should not ﬁnd that changes in sovereign CDS have any further explanatory power for changes in bank CDS.3. we again ﬁnd a negative coeﬃcient on sovereign CDS in the bailout period and an essentially zero coeﬃcient in the pre-bailout period. 4. The estimates are shown in Table 4. the results are quite similar to those in Table 3. its inclusion has little impact on the magnitude of the sovereign CDS coeﬃcient. then this is strongly supportive of a sovereign-to-bank feedback channel. their impact may be subsumed into an equity control. if one ﬁnds that sovereign CDS does have further explanatory power beyond equity returns.

Equation (12) suggests that we should ﬁnd that the magnitude of the coeﬃcient on changes in sovereign CDS is decreasing in banks’ Tier 1 ratios. Intuitively. we estimate the following regression: Bank Stock Returnijt = αi + δt + β∆ log(Sovereign CDSjt ) + γ∆Xijt + εijt where Bank Stock Returnijt is the stock return of bank i headquartered in country j from time t to time t − 1. Table 6 presents the results. Table 5 reports the results. the point estimates are clearly higher than for the post-bailout period. Columns (7) to (9) show that in the post-bailout period an increase in sovereign CDS is associated with a decrease in bank stock returns. the negative estimates for the interaction term indicate that banks with higher Tier 1 ratios were less sensitive to variation in sovereign CDS rates. 4. across the board. Similar to the post-bailout period. Note also that the coeﬃcients on the controls have the expected signs and are signiﬁcant. To that end. This result is robust to the inclusion of the full set of controls. For the post-bailout period. However. Although the estimates are negative in columns (7) to (9).3 The Impact on Equity Value For the purposes of establishing the existence of a two-way feedback we have mainly focused on changes in bank CDS. bank stock returns should reﬂect changes in sovereign credit risk due to their impact on the value of continuing bailout payments and banks’ holdings of government bonds. It is also interesting to look at the impact of bailouts on bank stock returns. this implies that well-capitalized banks experienced a larger CDS decrease relative to poorly capitalized banks during the bailout period.bank’s probability of solvency.3. the impact of changes in the value of government guarantees stronger for less well-capitalized banks. which includes the full set of controls is statistically signiﬁcant. the coeﬃcient on sovereign CDS is not distinguishable from zero during the bailout period. The point estimate is positive in columns (5) and (6). This speciﬁcation is motivated by the model. From the viewpoint of the model. The coeﬃcient of interest is the interaction term. In the pre-bailout period. which is consistent with the idea that equity holders 33 . the interaction term is positive but small and statistically insigniﬁcant. Perhaps somewhat surprisingly. Still. We use the same control variables as in Table 4. The results in the bailout period are surprising. but is not statistically signiﬁcant. only column (9). the coeﬃcient on the interaction term is negative.

To implement this test. we search for CDS prices in the database Datastream. The beneﬁt of this approach is that it circumvents the usual concerns about omitted country-speciﬁc macro shocks. Columns (1) to (3) show that as before.4% of bonds are issued by the country in which a bank is headquartered. These data were released as part of the European bank stress tests. the average bank had risk-weighted assets of 126 billion euros and a Tier 1 capital ratio of 10. Let SovBondik be the share of for- 34 . A total of 91 banks participated in the bank stress tests. This is supportive of the model’s assumption that banks are exposed to home-country sovereign risk through their holdings of government bonds. respectively. we match 51 banks to CDS prices. we use data on the sovereign bond holdings of European banks.beneﬁtted from bank bailouts. These banks represent about 70 percent of bank assets in Europe. Our test focuses uses information on changes in the value of foreignsovereign holdings rather than own-country sovereign holdings. We collect the stress test data from the websites of national bank regulators in Europe. We ﬁrst describe the data and provide summary statistics. Using bank names. For all banks. Banks have a strong home bias in their sovereign holdings: about 69. The average holdings of gross and net European sovereign bonds are 20. 4. the average bank holds about one sixth of risk-weighted assets in sovereign bonds.4 European Bank Stress Test Analysis As a ﬁnal part of our analysis.6 billion euros and 19. The data consists of bank characteristics and holdings of European sovereign bonds. the coeﬃcient on sovereign CDS in the pre-bailout period is essentially zero. we construct a bank-speciﬁc variable measuring variation in the value of banks’ foreign sovereign bond holdings. The data provide a view of a bank’s bond holdings of both its own government bonds and those of other European countries. We use these data to conduct an alternative test of the impact of sovereign credit risk on bank credit risk. Hence. For each bank we match sovereign holdings to sovereign CDS and compute a measure of exposure to sovereign credit risk.7 billion euros. Unmatched banks are mostly smaller banks from Spain and Eastern Europe that do not have publicly quoted CDS prices.2%. Table 7 presents summary statistics for all banks that participated in the European bank stress tests. One potential oﬀsetting eﬀect on this result is that in some countries the beneﬁts of bailouts to equity holders were oﬀset by charges (or expectations of charges) levied by the government. which were conducted in the ﬁrst half of 2010. As of March 2010.

35 . This does not have any eﬀect on the coeﬃcient. Column (3) controls for week ﬁxed eﬀects. We calculate the foreign holdings variable. Column (6) estimates the same regression as in Column (5) but excludes the holdings of German bonds from the construction of the foreignholdings variable. To further check for robustness. column (5) adds back bank ﬁxed eﬀects. The coeﬃcient of interest is γ. we are implicitly assuming that the marginal CDS investor either knows or at least has some idea of the bank holdings. the coeﬃcient is identiﬁed only oﬀ the cross-sectional variation in the value of foreign sovereign holdings. This coeﬃcient suggests that a one-standard deviation increase in the change in the foreign sovereign holdings variable leads to an increase of about half of a one-standard deviation in the change of the bank CDS. which captures the eﬀect of changes in the value of foreign bond holdings on the bank’s CDS. The column shows that this has no eﬀect on the coeﬃcient of interest. (13) where δt are time ﬁxed eﬀects. Column (1) shows a positive and statistically signiﬁcant association between changes in banks’ CDS and their foreign sovereign holdings. The coeﬃcient of interest decreases from 0. ForeignBondCDSit as the following weighted average: ForeignBondCDSit = i=j SovBondik ∗ SovereignCDSkt .141 but remains statistically signiﬁcant at the 1%-level. We then estimate the following: ∆ log(Bank CDSit ) = δt + γ∆ log(ForeignBondCDSit ) + εit . In this case. The coeﬃcient decreases to 0. This result suggests that variation in foreign sovereign holdings contains economically important information about variation in bank credit risk.eign sovereign holdings of country k by bank i. where SovereignCDSkt is the sovereign CDS of country k on day t. Table 8 shows the results. We do this to address a potential concern about reverse causality due to the possibility that Germany may provide bailouts to other countries. or banks in other countries.325 to 0. Column (2) shows that the coeﬃcient remains unchanged when bank ﬁxed eﬀects are included. This suggests that common shocks aﬀect both the change in bank CDS and the change in the foreign holdings variable. Column (4) controls for day ﬁxed eﬀects. Note that for each bank the foreign holdings variable excludes home-sovereign bonds.261. We estimate the regressions using the period one month before and one month after the reporting date for the sovereign bond holdings. By estimating this regression.

a cost of bank bailouts to the government or regulatory budget that is increasing in the quantity of bailout funds. 2010.b) considers the optimal taxation to fund bailouts in a continuous-time dynamic setting. Diamond and Rajan. 1989b) initiated a body of work that focused on ex-post costs to sovereigns of defaulting on external debt. Acharya. Panageas (2010a.. Bhattacharya and Nyborg. risk-shifting or asset substitution (e. imposition of international trade sanctions and conditionality in support from multi-national agencies. in a reduced-form manner. 2004). 2010.g. Philippon and Schnabl. Diamond and Rajan (2005. 2007). 2005).g. While the question of how necessarily involves an optimization with some frictions.g. Aghion. 2009). Bulow and Rogoﬀ (1989a. is weak. (iii) the recent empirical literature on eﬀects of bank bailouts on sovereigns.g. A large body of existing literature in banking considers that bank bailouts are inherently a problem of time consistency and induce moral hazard at individual-bank level (Mailath and Mester. the usual friction assumed is the inability to resolve failed bank’s distress entirely due to agency problems.. does consider ex-post costs of bailouts. as a whole. Shin and Yorulmazer. however.g. Diamond and Rajan. e. (ii) the literature on costs of sovereign default. They provide taxation-related ﬁscal costs as a possible motivation. 1994) and at collective level through herding (Penati and Protopapadakis. 2008.. among others) focus on speciﬁc claims through which bank bailouts can be structured to limit these frictions. In the theoretical literature on sovereign defaults. 1988. due to reputational hit in future borrowing. Brown and Dinc (2009) show empirically that the governments are more likely to rescue a failing bank when the banking system. 2008) model. Broner and Ventura 36 . adverse selection (e. Gorton and Huang. 2006) study how bank bailouts can take away a part of the aggregate pool of liquidity from safe banks and endanger them too.5 Related literature Our paper is related to three diﬀerent strands of literature: (i) the theoretical literature on bank bailouts. Some other papers (Philippon and Schnabl. or tradeoﬀ between illiquidity and insolvency problems (e. 2009). also highlighting when banks might be too big to save. and. The theoretical literature on bank bailouts has mainly focused on how to structure bank bailouts eﬃciently. Notably. Acharya and Yorulmazer... Acharya and Yorulmazer (2007. This could be due to under-investment problem as in our setup (e. Bolton and Fries (1999) consider the cost that bank debt restructuring can in some cases delay the recognition of loan losses. A small part of this literature.

primarily of bank creditors. Checherita and Nickel (2009) focus on the eﬀect of bank bailout announcements on sovereign credit risk measured using CDS spreads. consider a collateral damage to the ﬁnancial institutions and markets when a sovereign defaults. Martin and Ventura (2007). These eﬀects are potentially all consistent with our 37 . Another strand of recent empirical work relating ﬁnancial sector and sovereign credit risk during the ongoing crisis shares some similarity to the very recent papers on this theme. Finally. bank creditors were backstopped reﬂecting a waiting game on part of bank regulators and governments. especially beyond a threshold of 90% debt to GDP ratio of the sovereign. and private debt shrinks signiﬁcantly while sovereign debt rises. Veronesi and Zingales (2009) conduct an event study and speciﬁcally investigate the U. among others. Acharya and Rajan (2010) and Gennaioli. producing a downward revision in CDS spreads of the former. One strand of recent empirical work focuses on the distortionary design of bank bailout packages. Reinhart and Rogoﬀ (2009a. They ﬁnd that the government intervention increased the value of banks by over $100 billion.(2005). Demirguc-Kunt and Huizinga (2010) do an international study of equity prices and CDS spreads around bank bailouts and show that some large banks may be too big to save rather than too big to fail. In particular. Some of their evidence mirrors our descriptive evidence. Sgherri and Zoli (2009) and Attinasi. Our analysis corroborates and complements some of this work. Acharya and Sundaram (2009) document how the loan guarantee program of the Federal Deposit Insurance Corporation in the Fall of 2008 was charged in a manner that favored weaker banks at the expense of safer ones. an ex-post deadweight cost of sovereign default in external markets as well as an internal cost to the ﬁnancial sector through bank holdings of government bonds. after a ﬁnancial crisis). Dieckmann and Plank (2009) analyze sovereign CDS of developed economies around the crisis and document a signiﬁcant rise in co-movement following the collapse of Lehman Brothers. Broner. b) and Reinhart and Reinhart (2010) document that economic activity remains in deep slump “after the fall” (that is. our empirical investigation of banking sector holdings of government debt and how this introduces a linkage between bank CDS and sovereign CDS is novel. Martin and Rossi (2010). Our model considers both of these eﬀects. They employ this as a possible commitment device that gives the sovereign “willingness to pay” its creditors.S. but also estimate a tax payer cost between $25 to $47 billion. government intervention in October 2008 through TARP and calculate the beneﬁts to banks and costs to taxpayers. Panetta et al. (2009) and King (2009) assess the Euro zone bailouts and reach the conclusion that while bank equity was wiped out in most cases.

Using credit ratings data and data on sovereign bond holdings from the European bank stress test in May 2010. In the shortrun. Hyun Song Shin and Tanju Yorulmazer. “Crisis Resolution and Bank Liquidity”. even inﬂation) risk imposed on corporate and household sectors of the economy. Chapter 15 in Acharya. Viral V. which dilutes the value of existing government bonds and creates a two-way feedback mechanism because ﬁnancial ﬁrm hold government bonds for liquidity purposes. New York University Stern School of Business Acharya. Taking cognizance of this ultimate cost of bailouts has important consequences for the future resolution of ﬁnancial crises. References Acharya. bailouts are funded through the issuance of government bonds. “The Financial Sector ‘Bailout’: Sowing the Seeds of the Next Crisis”. and Matthew 38 . 6 Conclusion This paper examines the intimate and intricate link between bank bailouts and sovereign credit risk. Overall. This cost is a reﬂection of the future taxation (or more generally. Work in progess.model of how ﬁnancial sector bailouts aﬀect sovereign credit risk and economic growth. 2009. Review of Financial Studies. the design of ﬁscal policy. Such an ex-post cost of bailouts has received little theoretical attention and has also not been analyzed much empirically. Viral. In particular. Viral V. and Raghuram G. we document that developed country governments transferred credit risk from the ﬁnancial sector to taxpayers during the height of the crisis in October 2008. we consider the emergence of meaningful sovereign credit risk as an important potential cost of bank bailouts. We also provide supporting evidence for our model using data from the ﬁnancial crisis of 2007-10. and the nexus between the two. we ﬁnd that sovereign credit risk in turn aﬀected bank credit risk. 2010. forthcoming. Viral V. We develop a model in which the government faces an important trade-oﬀ: bank bailouts ameliorate the under-investment problem in the ﬁnancial sector but reduce investment incentives in the non-ﬁnancial sector due to costly future taxation. 2008. and Rangarajan Sundaram. Acharya. “Financial Sector and Sovereign Credit Risk”. Rajan.

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Anglo Irish Bank. . Bank of Ireland. The bank CDS is computed as the unweighted average of bank CDS for banks headquartered in Ireland (Allied Irish Bank. The data are from Datastream.Figure 1: Sovereign CDS and bank CDS of Ireland 01jan2007 0 200 400 600 800 01jan2008 (mean) cds 01jan2009 date 01jan2010 (mean) countrycds 01jan2011 Figure 1 plots the sovereign CDS and bank CDS for Ireland in the period from 3/1/2007 to 8/31/2010. and Irish Life and Permanent).

1]. α = 1.3 Value of Government’s Objective Function Gov. gov.15 τ 0.1 0. dL dG/dT0 and dL/dτ 0.5. γ = 0. dashed line) as functions of T for the certainty model of Section 3. The dash-dot line corresponds to a higher level of existing government debt. D = 0. β = 0.5.2. m = 1.25 (solid line). Objective Value val. The plots correspond to a parameterization of the model where A1 ∼ U [0.1 0.3 The top panel of Figure 2 plots the marginal gain (dG/dT ) of raising tax revenues (solid line and dash-dot line) and the marginal loss (dL/dT .3.15 τ 0.3. ϑ = 0.05 0. than the solid line. ND . L1 = 0.2 0.3.25 0.Figure 2: Marginal Gain and Loss of Raising T (Certainty Case) dG vs.05 0. with the the solid and dash-dot line corresponding to their counterparts in the top ˜ panel. and ND = 0. The bottom panel of the Figure shows the resulting value of the government’s objective function (equation (3)). k = 0.25 0.2 0. obj 0. .02.

2 Default ND 0.3 0.7 0.8 0.05 0 0.Figure 3: The Default Boundary (Certainty Case) Default and No−Default Regions 0.6 L1 0.1 No Default 0.3 0.4 0.9 Figure 3 shows the Default and No-Default Regions in the space of L1 × ND (ﬁnancial sector leverage/debt overhang × pre-existing sovereign debt) for the certainty model parameterized as in Figure 2.15 0.2 0.25 0. . The black curve separating these two regions gives the Default Boundary.5 0.

25.4].5 (solid line).06.4 1. objective 0.8 1 1.6 Value of Government’s Objective Function value of gov.5. γ = 0. Uncertainty over growth/tax revenues. D = 0. dL dG/dH and dL/dH 0.2 2. m = 1.Figure 4: Marginal Gain and Loss of Increasing H dG vs.4 1.4 2. dG/dH (solid line and dash-dot line) and the resulting marginal increase in expected dead-weight default cost D dpdef (dashed line).3.2. The plots correspond to a ˜ ˜ parameterization of the model where RV ∼ U [0.6 The top panel of Figure 4 plots the marginal gain of increasing H while holding constant T . ϑ = 0. and ND = 0. .6 H 1.3. k = 0.4 2.6. with the the solid and dash-dot line corresponding to their counterparts in the top panel. The dash-dot line corresponds to a higher level of L1 than for the solid line. A1 ∼ U [0. 1].8 1 1. α = 1. dH ˜ RV . The bottom panel of the Figure shows the resulting value of the government’s objective function.8 2 2. is assumed to have a uniform distribution.2 1.2 1. L1 = 0. β = 0.2 2.6 H 1. 1.8 2 2.

2 ND 0.1 0.2 ND 0.1 0.2 ND 0.Figure 5: Comparative Statics for L1 0.3 0.4 0.6 L1 0.8 P0 T0 0.8 H τ 0.8 0.1 0.4 0.3 0.4 P0 T0 0. The dotted line in the plots represents the point at which total default (H → ∞) is optimal.4 0.4 Figure 5 plots the equilibrium values of T (expected tax revenue).4 H τ 0.6 L1 0. . H.6 L1 0.4 0. and P0 (price of sovereign bond) as L1 (top panel) and ND (bottom panel) are varied. T0 (the transfer). The parameters of the model correspond to those in Figure 4.3 0.4 0.8 Comparative Statics for ND 0. resulting in a discontinuity in the plot.6 L1 0.3 0.1 0.2 ND 0.

Bank of Ireland. Anglo Irish Bank. The bank CDS is computed as the unweighted average of bank CDS for banks headquartered in Ireland (Allied Irish Bank.Figure 6: Change in Sovereign and Bank CDS before Bank Bailouts 450 400 350 300 250 basis points 200 Sovereign CDS Bank CDS 150 100 50 0 ‐50 Figure 6 plots the sovereign CDS and bank CDS for Ireland in the period from 3/1/2007 to 8/31/2010. and Irish Life and Permanent). The data are from Datastream. .

.Figure 7: Change in Sovereign and Bank CDS during the Period of Bank Bailouts 100 50 0 AT AU BE CH DE DK ES FR GB GR IE IT NL NO PT SE ‐50 Sovereign CDS Bank CDS ‐100 basis points ‐150 ‐200 ‐250 Figure 7 plots the change in average bank CDS and sovereign CDS for Western European countries in the period from 9/26/2008 to 10/21/2008. The data are from Datastream (no data available for Switzerland Country CDS and Greek banks CDS during this period). The bank CDS is computed as the unweighted average of bank CDS for banks headquartered in that country.

. The bank CDS is computed as the unweighted average of bank CDS for banks headquartered in that country. The data are from Datastream.Figure 8: Change in Sovereign and Bank CDS after Bank Bailouts 1200 1000 800 600 Sovereign CDS Bank CDS 400 200 0 ‐200 Figure 8 plots the change in average bank CDS and sovereign CDS for Western European countries in the period from 10/22/2008 to 6/30/2010.

The top ﬁgure shows no correlation before the bailouts (as of 3/1/2007). . The bottom ﬁgure shows a strong correlation after the bank bailouts (as of 3/1/2010). The data are from Datastream and the OECD Economic database.Figure 9: Correlation between Sovereign CDS and Public Debt before and after bank bailouts Figure 9 shows the correlation between sovereign CDS and public liabilities (as a percentage of GDP) for Western European countries before and after the bank bailouts.

055 0.246 -0.8 1.496 6.0 12.267 65.079 -0.082 0.8 -0.034 0.9 9.4 41.341 0.6 3. The sample includes all European.101 606 0.9 20.5 10.174 0. 2010.896.045 -0.067 0.1 90.2 606 0.074 0.122 -0.3 26.0 1.027 0.000 -0.633 0.177 0.5 5th 50th Percentile Percentile 362.005 178.630 0.5 2.003 -0.017 -0.7 0.002 -0.8 1.100 0.249 0.102 3.041 0.058 455 -0.032 606 0.5 6.1 10.5 4.1 138.2 159.859 -0.496 194. 2007.5 81.042 0.519 0.495 6.018 -0.043 Post-Bailout (31/10/2008 .8 244.8 6.089 131.003 -0.138 0.324 0.495 6.2 6.103 0.Table 1: Summary Statistics The sample show cross-sectional and time-series summary statistics for the bank risk sample.3 615.122 0.333 0.136 0.7 1.5 58.130 Bank CDS (bp) Sovereign CDS (bp) CDS Volatility Bank Stock Return (%) ∆ Bank CDS (%) ∆ Sovereign CDS (%) ∆ CDS Market Index (%) Bank CDS (bp) Sovereign CDS (bp) CDS Volatility Bank Stock Return (%) ∆ Bank CDS (%) ∆ Sovereign CDS (%) ∆ CDS Market Index (%) Bank CDS (bp) Sovereign CDS (bp) CDS Volatility Bank Stock Return (%) ∆ Bank CDS (%) ∆ Sovereign CDS (%) ∆ CDS Market Index (%) .S.278 0.378 0.4 65.016 0.002 0.199 Bailout Period (9/1/2008-10/31/2008) # Mean Std.129 0.9 112.095 -0.Dev 606 301.9 100.6 Std.137 0.6 77.610 0.207 -0.208 0.281 3.633 12.9 28.633 0.4 10.5 6.302 3.4 11.001 -0.9 13.079 -0.043 0.217 727.8 0.496 6.002 0.2 3.633 98.001 0.496 4.5 24.140 0.518 0.038 2.8 5. U.9 29.033 605 0.000 -0.7 -0.008 0.001 0.3 37. 2007 to August 31st.5 -0.515 -0.814 6.6 3..Dev 594. Panel A shows summary statistics for the week of July 1st.168 0.0 52.028 0. The data are the weekly level.174 -0.003 0. Panel B shows summary statistics for the period from January 1st. Panel A: Cross-Section (7/1/2007) # Assets ($ billion) Equity ($ billion) Equity Ratio (%) Tier 1 Ratio (%) Bank CDS (bp) Sovereign CDS (bp) 81 81 81 66 75 56 Mean 589.5 95th Percentile 1.7 -0.1 8.3 2.009 65.015 0.124 95th Percentile 293.6 21.364 -0.0 0.1 Panel B: Time-Series Pre-Bailout Period (1/1/2007-8/31/2008) 5th 50th Percentile Percentile 3.2 0.7 606 33.5 21.004 -0.373 567.9 8.9 8. and Australian banks with available data on bank CDS and share prices.31/8/2010) 6.

137** (0. We report robust standard errors. and bank quality.Table 2: Emergence of Sovereign Credit Risk This table shows the relation between sovereign credit risk. Sweden. Columns (1) and (2) control for Public Debt measured as General Government Gross Financial Liabilities as percentage of GDP (collected from the OECD Economic Outlook).843 3.112** (0.171 0. The dependent variables are the public debt in June 2008 and average bank quality.118+ (10.726+ (11. respectively.401) 17 0. Denmark.154) 14 0. The dependent variable is the average bank quality. Column (2) controls for average bank quality measured as the average banks CDS before the bank bailouts (as of 9/22/2008).601 (1. The independent variable in column (6) is public debt in June 2010.357) -1. and Switzerland with publicly available data on sovereign and bank CDS. The independent variable in column (5) is the change in public debt from June 2008 to June 2010.923) 15 0.015* (0.005 (0. and + 10% significant Log (Sovereign CDS) Pre-Bailout Post-Bailout 1/1/2008 3/31/2010 % Public Debt (June 2008) Log (Average Bank CDS Sep 2008) Constant 2.208) 0.168) -86. public debt.965* (0.004) 0.013+ (0.006) 0.007) 0. The independent variable in Columns (3) and (4) is the sovereign CDS after the bank bailouts (as of 3/31/2010).548 (60.488 % Public Debt Around Bailout Post-Bailout ∆ 2010-2008 3/31/2010 1.005) 0.311 (0.006 (0.593 (2. The data are at the countrylevel.364 Observations R-squared . The independent variable in Columns (1) and (2) is the sovereign CDS before the bank bailouts (as of 1/1/2008). Great Britain. * 5% significant.555) -101.261 20. The sample includes all Eurozone countries and Australia.320) 15 0.456) 15 0.920 (49.107** (0.019) 15 0.144) 21. The dependent variables are the same as in Columns (1) and (2).134 0. ** 1% significant.

The data are at the weekly level.316 Y N 7.508 84 0.023* (0.384 Y Y 7. The control variables are the change in CDS market index. Columns (4) to (6) cover the bailout period (9/1/2008-10/31/2008).079** (0.015) Around Bailout (Sep-Oct 08) (4) (5) (6) 0. U.026 (0.860** (0.027) Week FE Interactions Observations Banks R-squared .S.134 Y N 577 71 0.027) 0.163** (0.689** (0.086 84 0. (3).403+ (0.232) -0.253 Y Y 3.508 84 0.504 -0. and Australian banks with available data on bank CDS and share prices.430 (0. (5).387 0. Column (3).308 Y Y 577 71 0.019 (0.082) 0. The main independent variable is the weekly change in the sovereign CDS.Table 3: Change in Bank and Sovereign Credit Risk This table shows the effect of sovereign credit risk on bank credit risk during the financial crisis. (6).441 0. and the CDS Market index.122* (0.015 (0.094) -0.081) N N 577 71 0.080** (0. volatility.019) 0. (9) include bank fixed effects and interactions of bank fixed effects with volatility.287) Post-Bailout (Nov 08-Sep 10) (7) (8) (9) 0. The standard errors are clustered at the bank-level.014) 0. and bank stock return.155) N N 3. Columns (1) to (3) cover the pre-bailout period (1/1/2007-31/8/2010). The sovereign CDS is assigned based on the country where the bank is headquartered.086 84 0.171 Y N 3.539** (0.030) 0. Columns (2).932** (0.508 84 0.086 84 0. * 5% significant.041) 0. and Columns (7) to (9) cover the post-bailout period (November 2008 to August 2010). ** 1% significant.050) N N 7. (8). The dependent variable is the weekly change in the natural logarithm of bank CDS. and + 10% significant ∆ Log(Bank CDS) Period ∆ Log(Sovereign CDS) ∆ Log(CDS Market Index) ∆ Volatility Index Pre-Bailout (Jan 07-Aug 08) (1) (2) (3) 0.010) 0.. bank stock return. The sample includes all European.214 (0. and (9) include week fixed effects. (6).

308 Y Y 2. The main independent variable is the weekly change in the sovereign CDS. volatility. and bank stock return.235 (0.105** (0.062 (0.153) -0.043) 0.020 (0.200) Post-Bailout (Nov 08-Sep 10) (7) (8) (9) 0.034) 0.359 Y N 5.106) 0.030 (0.848** (0.711** (0.096) -0. Columns (4) to (6) cover the bailout period (9/1/2008-10/31/2008). and + 10% significant ∆ Log(Bank CDS) Period ∆ Log(Sovereign CDS) Bank Stock Return ∆ Log(CDS Market Index) ∆ Volatility Index Pre-Bailout (Jan 07-Aug 08) (1) (2) (3) 0.Table 4: Change in Bank and Sovereign Credit Risk This table shows the effect of sovereign credit risk on bank credit risk during the financial crisis.745 63 0.491 0.032) 0.030) Week FE Interactions Observations Banks R-squared .278 60 0.174** (0. (5). (9) include bank fixed effects and interactions of bank fixed effects with volatility.100** (0. and Australian banks with available data on bank CDS and share prices.034) -0.118) 0.015) Around Bailout (Sep-Oct 08) (4) (5) (6) -0.255+ (0.154** (0.S.008 (0.929** (0.403 Y Y 437 53 0.278 60 0.043 (0. ** 1% significant. (6).. and (9) include week fixed effects.424 Y Y 5. The control variables are the change in CDS market index. Columns (2). U. and Columns (7) to (9) cover the post-bailout period (November 2008 to August 2010). (8).120) N N 2.481 0.278 60 0.014 (0.295* (0.150** (0.096) N N 437 53 0. (6).728 -0.236 (0. The data are at the weekly level. Column (3). bank stock return. * 5% significant. Columns (1) to (3) cover the pre-bailout period (1/1/2007-31/8/2010).224 Y N 2. The sample includes all European.009) -0.745 63 0.142 (0.132) 0. and the CDS Market index. The dependent variable is the weekly change in the natural logarithm of bank CDS. The sovereign CDS is assigned based on the country where the bank is headquartered.013) -0. The standard errors are clustered at the bank-level.123) -0.662** (0.208 Y N 437 53 0.036) 0. (3).051) N N 5.019* (0.147) -0.745 63 0.025) -0.

648 (0.568) -0. U. Columns (1) to (3) cover the pre-bailout period (1/1/2007-31/8/2010). All other controls are the same as in Table5.011 (12.400) -0.163 47 0..380 -1.S. and Columns (7) to (9) cover the post-bailout period (November 2008 to August 2010).335** (0.114 (8.096) Post-Bailout (Nov 08-Sep 10) (7) (8) (9) -1.256 48 0.347** (0.237) 61.126) -2.165** (0.224) -0.028) -0. All other variables are defined in Tables 3 to 5.360) 0. The Tier 1 capital ratio is the regulatory bank capital ratio.115) Y Y N 2.261 0. The sample includes all European.792) -0.019 (0.163 47 0.883) -0.510 Y Y Y 351 41 0.340 (0.095) Y N N 2. and + 10% significant ∆ Log(Bank CDS) Around Bailout (Sep-Oct 08) (4) (5) (6) -6.470) 0. The regression includes the Tier 1 capital ratio and an interaction between the Tier1 capital ratio and the change in sovereign CDS.589 (8.976) 0.054 (0.437 (0.317* (0.035) -0.037) Y N N 4.493) 0.072) -15.517 .256 48 0.492 (32.265* (2.139) Y N N 351 41 0.730+ (3.Table 5: Change in Bank and Sovereign Credit Risk (by Tier 1 Capital) This table shows the effect of sovereign credit risk on bank credit risk during the financial crisis.118) Other Controls Week FE Interactions Observations Bank R-squared Y Y Y 2.368** (0.134** (0. The dependent variable is the weekly change in the natural logarithm of bank CDS.937 (108.804 Y Y Y 4.066) -13. * 5% significant. ** 1% significant.712) -0.449 -2. and Australian banks with available data on bank CDS and share prices.118 (30. Columns (4) to (6) cover the bailout period (9/1/2008-10/31/2008).117 (0. The data are at the weekly level.079 (0. The standard errors are clustered at the bank-level.087 (78.423) 0.345 1.182) Period ∆ Log(Sovereign CDS)*Tier 1 ∆ Log(Sovereign CDS) Tier 1 Stock Return Pre-Bailout (Jan 07-Aug 08) (1) (2) (3) 0.140) Y Y N 351 41 0.014 (1.032 (1.528 -4.882) -0.575* (0.353 -6.163 47 0.337* (0.824* (1.031 (0.610 (1.256 48 0.765 (1.336) 67.127) -1.043) Y Y N 4.823) 0.

(6).054* (0. * 5% significant. Columns (4) to (6) cover the bailout period (9/1/2008-10/31/2008).011** (0.026) -0. Columns (2).895 65 0.078) -0.564 0.041 (0. and (9) include week fixed effects. Columns (1) to (3) cover the pre-bailout period (1/1/2007-31/8/2010).324 60 0.015) -0.004) -0.002 (0. (9) include bank fixed effects and interactions of bank fixed effects with volatility and the CDS Market index. and + 10% significant Bank Stock Return Around Bailout (Sep-Oct 08) (4) (5) (6) -0. and Columns (7) to (9) cover the post-bailout period (November 2008 to August 2010).035) -0.070 -0.057) N N N 5.324 60 0. (3). The control variables are the change in CDS market index and volatility.317** (0.106** (0.017) -0.243** (0.002 (0. (6).002) Post-Bailout (Nov 08-Sep 10) (7) (8) (9) -0.002) -0.177** (0.474** (0. ** 1% significant. The sovereign CDS is assigned based on the country where the bank is headquartered.082) Y N N 2.114 (0.026) Week FE Bank FE Interactions Observations Banks R-squared .240 Y Y Y 2.311 N N N 446 54 0. (5). (8).212 Y Y Y 446 54 0.S.285 Y N N 5.895 65 0. The sample includes all European..324 60 0. Column (3). and Australian banks with available data on bank CDS and share prices.040 (0.068** (0. The data are at the weekly level.114) Period ∆ Log(Sovereign CDS) ∆ Log(CDS Market Index) ∆ Volatility Index Pre-Bailout (Jan 07-Aug 08) (1) (2) (3) -0.075) 0.070) N N N 2.895 65 0.761** (0.368** (0.026) -0. The dependent variable is the weekly bank stock return. U. The standard errors are clustered at the bank-level.118 Y N N 446 54 0.Table 6: Bank Stock Return and Change in Sovereign Credit Risk This table shows the effect of sovereign credit risk on bank stock returns during the financial crisis. The main independent variable is the weekly change in the sovereign CDS.533 -0.488 Y Y Y 5.

March 31.930 6.719 11. EUR million) Sovereign Holdings (net.948 27.493 11.601 100.Table 7: Summary Statistics of European Bank Stress Test Sample The table shows summary statistics for all banks that participated in the EU Bank Stress Tests from July 2010. The data was collected from the website of the Committee of European Banking Regulators and nation websites of the respective bank regulators.269 7.2 105 105 182 117 18.023 69.307 14.422 13.2 493.960 5.6 0 92. EUR million) Home Share (%) Greek Sovereign Holdings Share Banking Book (%) 91 91 126.130 2.9 27. The sovereign holdings are computed as the total value of sovereign holdings relative to risk-weighted assets.0 2.8 3. We report both the gross and net exposure as reported to bank regulators.9 7.448 9.668 19.0 .329 14.2 179.956 30. The shares are computed based on gross exposure (net exposure was not reported).4 63.800 42. EUR million) Home Sovereign Holdings (gross.959 42. 2010 N (1) Bank Characteristics Risk-weighted Assets (EUR million) Tier 1 Capital Ratio (%) Sovereign Exposure Sovereign Holdings (gross.4 669 84.4 81.9 0 35.765 78. Sovereign Holdings Euro Bank Stress Tests Sample.800 100 5. EUR million) Home Sovereign Holdings (net.844 19.337 10.348 81. The share of trading book and banking book are the share of sovereign holdings held in the respective book.Dev (3) 50th Percentile (4) 5th Percentile (5) 95th Percentile (6) 91 91 91 91 91 91 91 20.4 Mean (2) Std.774 5.

173 0.317 51 0.317 51 0.046) Y N Y 2.173 0.329 0.317 51 0. Column (3) includes week fixed effects.027) N N N 2.261** (0.317 51 0.326** (0. Changes are computed as log changes. and +10% significant Change in Bank CDS Sample All (1) All (2) All (3) All (4) All (5) Excluding Germany (6) Change in Sovereign Exposure 0.049) N N Y 2. The data covers the period from 3/1/2010 to 4/30/2010.357 0.357 0.028) Y N N 2. (5) and (6) include bank fixed effects. Column (4) to (6) include day fixed effect.317 0. We construct the exposure variable as the weighted average of country CDS with sovereign holdings as weights.224 0.357 0.170 0. The standard errors are clustered at the bank-level (51 banks). ** 1% significant.027) N Y N 2.342 0. The sovereign bond holdings data were collected from the website of the Committee of European Banking Regulators and nation websites of the respective bank regulators.141** (0.317 51 0. * 5% significant.046) Y N Y 2.135** (0.188 0. Columns (2).325** (0.329 Bank FE Week FE Day FE Observations Banks R-squared Adjusted R-Squared . The exposure variable in Column (6) excludes German bonds.228 0.329 0.Table 8: Summary Statistics of European Bank Stress Test Sample The table shows regression of change in bank CDS on change in exposure to sovereign bank holdings.137** (0.

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