Introduction Model Empirics Conclusion A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk Viral Acharya, Itamar Drechsler and Philipp Schnabl ⋄ ⋄ NYU Stern May 2011 Viral Acharya, Itamar Drechsler and Philipp Schnabl A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
Introduction Model Empirics Conclusion Questions 1 Did financial sector bailouts ignite sovereign credit risk in the developed economies? were there important immediate costs to the bailouts (as opposed to just distortions of future incentives) What mechanisms underlie the relationship between financial sector and 2 sovereign credit risk? transmission of risks (spillover) between the sectors trade-off between financial sector and sovereign credit risk Does sovereign credit risk also feedback onto financial sector credit risk? 3 Viral Acharya, Itamar Drechsler and Philipp Schnabl A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
Introduction Model Empirics Conclusion Motivation: Bailout of Irish Banks Viral Acharya, Itamar Drechsler and Philipp Schnabl A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
Introduction Model Empirics Conclusion From Financial Sector Credit Risk to Sovereign Credit Risk On September 30, 2008 the government of Ireland announced a guarantee of all deposits of its six biggest banks Credit default swap (CDS) fee for buying protection on Irish banks fell from 400 bps to 150 bps From the standpoint of stabilizing the financial sector, the end goal of the guarantees appeared to have been met But at what cost? What impact would these provisions have on the credit risk of the government of Ireland? Viral Acharya, Itamar Drechsler and Philipp Schnabl A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
Introduction Model Empirics Conclusion Bailouts and Risk Transfer Just one of the Irish banks, Anglo Irish, had cost the government up to Euro 25 Billion or 11.26% of GDP by Aug’10 Ireland received 85 Billion Euro rescue package by European Union and IMF in Nov’10 and now needs another 24 Billion Euro for lenders Total is approximately 70% of 2010 GDP Ireland CDS spread now above 600 bps Viral Acharya, Itamar Drechsler and Philipp Schnabl A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
Introduction Model Empirics Conclusion A Motivating Example: The Case of Ireland 800 600 400 200 0 01jan2007 01jan2008 01jan2009 01jan2010 01jan2011 date (mean) cds (mean) countrycds Chart similar across many countries: 1 sovereign CDS close to 0 through first-half 2008 post bailout announcement (9/30/2008): sovereign CDS jumps up, bank CDS drops 2 down subsequent positive comovement 3 Viral Acharya, Itamar Drechsler and Philipp Schnabl A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
Introduction Model Empirics Conclusion Did Ireland have a choice? – Iceland vs. Ireland CDS 1600 1400 1200 1000 800 Ireland Iceland 600 400 200 0 Viral Acharya, Itamar Drechsler and Philipp Schnabl A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
Introduction Model Empirics Conclusion Pre-Bailouts: Europe 450 400 350 300 250 basis points Sovereign CDS 200 Bank CDS 150 100 50 0 ‐ 50 3/1/2007 – 8/31/2008 bank CDS has increased substantially not much change in sovereign CDS Viral Acharya, Itamar Drechsler and Philipp Schnabl A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
Introduction Model Empirics Conclusion During the Bailout Period 100 50 0 AT AU BE CH DE DK ES FR GB GR IE IT NL NO PT SE ‐ 50 basis points Sovereign CDS Bank CDS ‐ 100 ‐ 150 ‐ 200 ‐ 250 9/26/2008 – 10/21/2008 bank CDS decreases substantially strong increase in sovereign CDS Viral Acharya, Itamar Drechsler and Philipp Schnabl A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
Introduction Model Empirics Conclusion Post Bailout 1200 1000 800 600 Sovereign CDS Bank CDS 400 200 0 ‐ 200 10/22/2008 – 6/30/2010 positive comovement a merger of financial sector and and sovereign? Viral Acharya, Itamar Drechsler and Philipp Schnabl A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
Introduction Model Empirics Conclusion Pre- and Post-Bailout Sov CDS and Public Debt 400 GR 300 Sovereign CDS 200 HU IE PT ES IT 100 PL KR GB CZ SK AT BE FR US AU CH SE DK NL DE ES FI HU KR NO SE PL AU IE SK CZ DK NL NO GR IT AT DE FR PT 0 BE 0 50 100 150 Public Debt/GDP 3/1/2010 Fitted values 1/1/2007 Fitted values Sov. CDS vs. Debt/GDP Viral Acharya, Itamar Drechsler and Philipp Schnabl A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
Introduction Model Empirics Conclusion This Paper Models trade-off between sovereign and financial sector credit risk Government can transfer resources to financial sector Transfer alleviates under-provision of financial services (debt overhang) Funding the transfer induces underinvestment in corporate sector and dilutes existing sovereign bondholders Solve for optimal transfer ("bailout") and resulting sovereign bond price (CDS) in equilibrium Under certainty about future output and no-default 1 2 Allowing for strategic default Under uncertainty about future output 3 Empirical evidence from financial crisis of 2007 to 2010 Viral Acharya, Itamar Drechsler and Philipp Schnabl A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
Introduction Model Empirics Conclusion Model Three dates: t = 0, 1, 2 Sectors: Financial, Corporate, and Government Financial sector: �� � � 0 − L 1 + ˜ w s s s − c ( s s max E 0 A 1 + A G + T 0 × 1 { − L 1 + ˜ 0 ) A 1 + A G + T 0 > 0 } s s 0 Produces financial services s s 0 for per-unit wage w s at cost of c ( s 0 ) 1 an input to corporate sector production revenue captured only if solvent at t=1 (otherwise goes to debtholders) � � Incentive to produce depends on p solv = E 0 1 { − L 1 + ˜ 2 A 1 + A G + T 0 > 0 } L 1 are liabilities due at t=1 ˜ A 1 uncertain payoff of assets at t=1 A G a fraction k A of outstanding sovereign debt crisis –> low p solv (debt-overhang)–> under-provision of financial services T 0 is value of govt transfer (bailout) Viral Acharya, Itamar Drechsler and Philipp Schnabl A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
Introduction Model Empirics Conclusion Corporate Sector Corporate sector: � � f ( K 0 , s d 0 ) − w s s d 0 + ( 1 − θ 0 )˜ max E 0 V ( K 1 ) − ( K 1 − K 0 ) s d 0 , K 1 Buys s d 0 financial services to produce output f ( K 0 , s d 0 ) at t=1 1 Makes investment K 1 at t=1 in project with uncertain payoff ˜ V ( K 1 ) at t=2 2 � � ˜ V ( K 1 ) = E 0 V ( K 1 ) = K γ 1 , 0 < γ < 1 Tax rate θ 0 set at t = 0 and levied at t = 2 3 funds existing govt debt and new transfer T 0 distorts incentive to invest → underinvestment: V ′ ( K 1 ) dK 1 = ( 1 − θ 0 ) V ′′ ( K 1 ) < 0 d θ 0 Example: HP threatens to reduce investment in Ireland if taxes hiked to fund bailout (11/21) expected tax revenue T = θ 0 V ( K 1 ) T rises in θ 0 then falls (Laffer curve) Viral Acharya, Itamar Drechsler and Philipp Schnabl A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
Introduction Model Empirics Conclusion The Government’s Problem 1 Risk-Neutral representative consumer owns bonds and equity ⇒ Government’s s objective is to maximize expected total output Uses Transfer (Bailout) to alleviate under-provision of financial services (debt-overhang) Funds the Transfer and Existing Govt Debt with Taxes: 2 Existing Debt: N D outstanding bonds with face value 1 Transfer: N T new bonds issued → T 0 = P 0 N T θ 0 ˜ Defaults if: V ( K 1 ) < N D + N T ⇒ deadweight loss of D Govt chooses tax rate θ 0 and new bond issuance N T to maximize total output: 3 subject to equilibrium conditions and price P 0 H = N T + N D = N T + N D Insolvency ratio T θ 0 V ( K 1 ) rewrite using T and H instead of θ 0 and N T Viral Acharya, Itamar Drechsler and Philipp Schnabl A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
Introduction Model Empirics Conclusion Marginal Gain and Loss of Raising T (Tax Revenue) Consider first certainty about future output, ˜ V ( K 1 ) = V ( K 1 ) , and no default H = 1 dG vs. dL dG/dT 0 and dL/d τ 0.05 0.1 0.15 0.2 0.25 0.3 τ Gov. Objective Value val. gov. obj 0.05 0.1 0.15 0.2 0.25 0.3 τ marginal gain: increased T 0 → increased s 0 marginal loss: increased T → greater underinvestment loss dashed line: increased L 1 (more severe debt-overhang) → increased marginal gain Viral Acharya, Itamar Drechsler and Philipp Schnabl A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
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