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

• Author: Lei Zhao
• Published date: 01 January 2018
• Date: 01 January 2018
• DOI: http://doi.org/10.1111/eufm.12124

DOI: 10.1111/eufm.12124

ORIGINAL ARTICLE

Market-based estimates of implicit government

guarantees in European financial institutions

Lei Zhao

ESCP Europe, France, Labex Refi,

France

Email: lzhao@escpeurope.eu

Abstract

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 causes’the sovereign’s default risk.

KEYWORDS

credit default swap, financial crisis, financial institutions, implicit

government guarantees, too-big-to-fail

JEL CLASSIFICATION

G01,G21,G28

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INTRODUCTION

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;24:79–112. wileyonlinelibrary.com/journal/eufm © 2017 John Wiley & Sons, Ltd.

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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.

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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 wills’for 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.

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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 2005–2013 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

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What is known as the Paulson’s 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.

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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.

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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 government’s 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 bailouts’substantial 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 country’s 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.

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RELATED LITERATURE

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.

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,

4

This

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

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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.

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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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