Market‐based estimates of implicit government guarantees in European financial institutions

AuthorLei Zhao
Publication Date01 Jan 2018
DOI: 10.1111/eufm.12124
Market-based estimates of implicit government
guarantees in European financial institutions
Lei Zhao
ESCP Europe, France, Labex Refi,
I exploit the price differential of credit default swap (CDS)
contracts written on debts with different levels of seniority
to measure the implicit government guarantees enjoyed by
European financial institutions from 2005 to 2013. I
determine that the aggregate guarantee increased substan-
tially during the recent financial crises and peaked at an
average of 89 bps in 2011. My analysis suggests that the
extent of implicit support depends on the type of financial
institutions and there exists a eurozone effect. Further
investigation of feedback relationship shows that the
guarantee implicitly offered by a government positively
Granger causesthe sovereigns default risk.
credit default swap, financial crisis, financial institutions, implicit
government guarantees, too-big-to-fail
Public subsidies have long been known to pose a serious threat to the stability of the financial system.
On the one hand, the presence of government guarantees extended to too-big-to-fail (TBTF)
The author would like to thank John Doukas (the Editor), an anonymous referee, Barbara Casu Lukac, Pramuan
Bunkanwanicha, Alberta Di Giuli, Alfonso Dufour, Louis H. Ederington, Christophe Moussu, René M. Stulz, Simone
Varotto and Chardin Wese Simen as well as participants at the 2014 International Conference of the Financial Engineering
and Banking Society (FEBS), the 2014 International Finance and Banking Society conference (IFABS), the 2014 Financial
Management Association (FMA) Annual Meetings, the Paris December 2014 Finance meeting, and Labex Refi Young
Scholar Research seminar for their helpful and constructive comments.
Eur Financ Manag. 2018;24:79112. © 2017 John Wiley & Sons, Ltd.
institutions may reduce market discipline and induce protected banks to take more risk (see Sironi,
2003). On the other hand, the guarantees may, through competition, push the protected banks
competitors toward higher risk-taking as documented in Gropp, Hakenes, and Schnabel (2011).
Implicit government guarantees (IGG) stem from the expectation that the government will lend support
to troubled financial firms that are deemed to be of systemic importance. As noted by Demirguc-Kunt
and Huizinga (2013), in practice, bank bailouts are often not limited to insured deposits alone because
wide-ranging bailout packages designed to avert large defaults are not only politically convenient but
might also be economically justifiable if they can prevent severe market dislocations. Using an event
study, Veronesi and Zingales (2010) estimate the economic benefit of the 2008 Paulson bailout plan in
a range from US$ 86 billion to US$ 109 billion.
The implication is that because it might not be
desirable to end government bailouts, it might not be possible to eliminate IGG completely. As a result,
plausible solutions to the moral hazard problem would involve strengthening the resilience of TBTF
institutions and shifting most of the cost of rescuing failing banks to the private sector. Indeed, several
measures have been suggested. Examples of such measures include, but are not limited to, the
following: (1) limits on leverage and higher capital requirements (Basel Committee on Banking
Supervision, 2010), (2) compulsory living willsfor financial institutions (French et al., 2010), and (3)
a broader adoption of bail-in arrangements through hybrid securities that can be converted into equity
in case of distress (Evanoff, Jagtiani, & Nakata, 2011). To facilitate the implementation of these
measures, it is critical to identify the evolution of TBTF subsidies.
This paper is devoted to measuring and better understanding implicit government support for
financial institutions. It contributes to the existing literature in several ways. First, to the best of my
knowledge, I am the first to investigate how information in different segments of the credit default
swap (CDS) market can be used to value IGG both for individual financial firms and at an aggregate
level. Second, unlike most previous research, which focuses on the bond market, this paper examines
the existence of a TBTF effect using information from the CDS market.
Blanco, Brennan, and Marsh
(2005) and Norden and Weber (2009) find that CDSs are a more accurate and informative measure of
credit risk than bond yields. Furthermore, CDSs tend to be more liquid than the bond market, especially
when credit conditions deteriorate (Acharya & Johnson, 2007). Third, I investigate whether the extent
of the implicit guarantees depends on the type of financial institution, specifically looking at
differences between banks and insurance companies. Fourth, I study the impact of new financial
regulations on such guarantees. Further, I explore the potential difference between eurozone and non-
eurozone financial firms with respect to IGG. Finally, in contrast to previous literature that examines
the relationship between sovereign and financial sector credit risk, I investigate the possible feedback
effect between implicit guarantees enjoyed by financial firms and sovereign default risk, using Granger
causality tests.
My analysis shows that the aggregate IGG in the European financial system increases substantially
in the aftermath of the subprime crisis. The average discount on default insurance peaks at 89 basis
points during the sovereign debt crisis, which corresponds to an annual subsidy of approximately 175
billion. Over the 20052013 period, the largest financial institutions in Europe have an implicit public
subsidy of approximately 18 basis points per year on average, which increases dramatically from only
What is known as the Paulsons plan is the joint intervention of the US Treasury and the Federal Deposit Insurance
Corporation announced on October 13, 2008, which injected US$ 125 billion into the ten largest US commercial banks
with the intention of stabilising the financial system.
A recent paper by Demirguc-Kunt and Huizinga (2013) also investigates the TBTF effect by exploiting CDS prices. My
paper is unlike theirs in the sense that they only use senior CDS spreads, whereas I use both senior and subordinated CDS
spreads. By doing so, I can directly measure the level of implicit government support.
approximately 1 basis point before the crisis to 25 basis points during the crisis. Individually, although
IGG varies across firms and over time, a few financial institutions consistently attract a large
proportion of the total implicit guarantees given by governments.
Investigating the difference between US banks and insurance companies, Acharya, Anginer, and
Warburton (2013) find that US insurance companies are not perceived to be implicitly supported by the
government, which challenges the evidence of US government involvement with the rescue of
American International Group (AIG) during the crisis. In contrast, I do find substantial implicit
guarantees in European insurance companies. However, in line with Acharya et al. (2013) I also find
that banks enjoy higher IGG than insurance companies, especially during the financial crisis. This may
reveal the fact that banks are perceived to be more systemically important and thus more likely to be
bailed out by the government during difficult times. I also provide evidence of the TBTF effect for
European financial firms. After controlling for default risk, interconnectedness and prevailing market
risk aversion, larger financial institutions tend to have higher IGG. Moreover, the IGG of larger
institutions is more sensitive to their default risk. In other words, larger firms benefit more than smaller
ones from governments implicit support when default risk increases. Interestingly, Basel III, a major
international regulatory response to the recent financial crisis, does not seem to reduce IGG. Within
Europe, eurozone financial firms are found to enjoy more IGG than non-eurozone ones, all else being
equal, which may raise unfair-competition issues.
Finally, this paper examines the feedback relationship between IGG and sovereign default risk. I
find that higher IGG leads to higher sovereign default risk because of bailoutssubstantial potential
impact on public finances. With respect to the impact on IGG from sovereign risk, my analysis suggests
two offsetting effects. On the one hand, when a countrys credit condition deteriorates, it is more
difficult for the government to provide support for distressed financial institutions and thus, perceived
IGG decreases. On the other hand, higher sovereign risk results in higher default risk in the banking
system because financial firms hold sovereign debt on their balance sheets and thus, sovereign credit
risk increases IGG.
The rest of the paper is organised as follows. In section 2, I review the literature. The methodology
and a description of the data are reported in sections 3 and 4, respectively. The empirical results are
discussed in section 5 and my conclusions are summarised in section 6.
An active CDS market has flourished around both senior and subordinated bank debt. The different
spreads of these two CDSs have the potential to indicate the magnitude of implicit guarantees. My
working assumption is that guarantees are extended to senior debt but not junior debt.
difference between the two contracts should be reflected in the different extent of the market discipline
exerted by the two types of debt holders and has been documented in the literature.
Although little research focuses directly on subordinated CDS, significant attention has long been
paid to subordinated debt. Since the mid-1980s, academics and regulators have suggested the use of
subordinated debt as a tool for increasing the market discipline on banks. Calomiris (1999) proposes
A recent example is the nationalisation of SNS, the fourth largest bank in the Netherlands, where only subordinated debt
was seized by the government in exchange for a bailout package.
This, however, could be relaxed as noted in Black et al. (2016), who explain that the magnitude of implied IGG can be
extracted from the price differential of the two CDS contracts provided the CDS spread on subordinated debt is less
sensitive to IGG.

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