In the aftermath of Lehman Brothers, nearly all eurozone countries have intervened heavily in the domestic banking sector by providing capital injections, debt or deposit guarantees (see Stolz and Wedow 2010). These measures placed large burdens on public balances. In fact, the correlation between sovereign and bank credit default swap (CDS) spreads in the eurozone rose from 0.1 to 0.8 between 2007 and 2013.
Once countries tapped their fiscal limits, the ECB stepped in by providing liquidity to banks on a massive scale and by intervening in sovereign debt markets. These events led to an intense debate among policymakers and researchers alike over the merits and risks of these policies. [...]
Based on a recent study (Fratzscher and Rieth 2015), this column addresses two main questions in the debate:
What are the effects of bank bailouts on credit default risks of banks and sovereigns?
What are the effects of ECB non-standard policies on these risks?
Bank bailouts and credit default risk
The effects of bank bailouts on sovereign and bank credit risk are not clear a priori. If bailouts are effective in preventing bank runs and improving the outlook for the economy, then they are expected to both lower the risk to the banking sector and to improve sovereign risk. However, if bailouts are so large in magnitude that they imply a major challenge to the sustainability of public debt, then such a transfer of risk can actually worsen sovereign risk, while improving the risk to banks. Indeed, our benchmark estimates suggest that a bailout shock that reduced bank spreads by 100 basis points drove up sovereign spreads by 12 basis points on average.
Non-standard ECB policy and credit risks
Regarding monetary policy, our model reveals substantial differences between the various non-standard measures implemented by the ECB during the European debt crisis. It suggests that the announcement of Outright Monetary Transactions was the most effective measure in lowering default risks in the Eurozone. On average, it reduced sovereign and bank credit default swap spreads by 56 and 34 basis points, respectively. Intuitively, our results show that the effects were stronger in the periphery than in the core and that sovereign spreads decreased by more than bank spreads. [...]
The introduction of three-year longer-term refinancing operations can also be regarded as a success, in particular with regard to default risk in the banking sector. Overall, the programme reduced bank CDS spreads by 22 basis points on average. [...]
Finally, the Securities Market Programme was not successful. We estimate an overall impact of an increase in bank spreads by 129 basis points on average. Again we find an intriguing yet intuitive difference between announcement and implementation effects. The former reduced bank spreads by cumulatively 80 basis points. The latter, however, raised spreads by 209 basis points; reflecting a crowding out of banks’ claims against governments by the ECB.
Our estimates suggest that both bank bailout policies and non-standard monetary policies by the ECB had a significant impact on default risks of sovereigns and banks in the eurozone. The results, however, show that neither of the two policies was unanimously successful. Thus, they entail a note of caution to policymakers that policies which are intended to reduce default risk can have opposite effects if they are not properly designed.
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