What cost does a national government pay when it bails out its banks? Can the cost of a bank bailout be so humungous as to imperil the sovereign?s credit standing itself? National policymakers across the world treated these questions as mere intellectual indulgence, but the recent crisis in Ireland forces policymakers to grapple with this important question. A recent piece of research by Professors Viral Acharya, Itamar Drechsler and Philipp Schnabl of the Stern School of Business at New York University highlights the fact that the direct costs of bank bailouts, even leaving aside the potential moral hazard concerns that bailouts create, can be prohibitive to national governments.
The basic point of their research can be summarised by plotting the spreads for Credit Default Swaps (CDS) for the Irish government as well as the Irish banks. CDS are financial instruments that provide protection against a possible default by a corporate/sovereign entity. Intuitively, CDS are similar to insurance contracts. When I buy car insurance, I buy protection against the possibility that my car suffers damage in an accident. Similarly, when an investor buys a CDS on Irish government (or on an Irish bank), the investor buys insurance to protect against the possibility that the Irish government (or the Irish bank) would default on its debt obligations. Therefore, the CDS spread is similar to the premium paid on an insurance contract. Greater the insurance premium, higher the implied risk.
On September 30, 2008, the government of Ireland announced that it had guaranteed all deposits of the six of its biggest banks. As part of the ?Eligible Liabilities Guarantee Scheme?, the Irish government provided an unconditional and irrevocable government guarantee for all eligible liabilities, which included deposits of up to five years maturity.
As explained above, the market?s assessment of the Irish government?s credit risk as well as that of its banks can be measured using the premiums charged on the respective CDS contracts. In this context, three different observations can be made. First, while the cost of purchasing such protection on Irish banks fell overnight from around 400 bps (100 bps equal 1%) to 150 bps, the CDS spreads for the government of Ireland?s credit risk rose sharply overnight. In fact, the CDS spread on the Irish government quadrupled to over 100 bps within a month of the bailout. Second, before the bailout in September 2008, the CDS spreads on the Irish government were remarkably stable even while the CDS spreads on the Irish banks were steadily widening since July 2007; in other words, before the bailout in September 2008, there was little correlation between the Irish government?s credit risk and that of its banks. In contrast, after the September 2008 bailout, the market?s assessment of the credit risk of Irish banks has moved in tandem with its assessment of Irish government?s credit risk. Third, within six months of the bailout, the CDS spread on the Irish government had reached 400 basis points, which was identical to the CDS spread for Irish banks on September 29, 2008. While there was a general deterioration of global economic health over this period, the risk of the Irish financial sector has been transferred substantially to the Irish government?s balance sheet.
Viewed in the light of the eventual bailout by the EU, the cost of this bailout has risen to dizzying heights, which has prompted 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 Irish government up to 25 billion euros. This amount equals a third of the rescue package announced by the EU and amounts to 11.26% of Ireland?s 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.? However, the bank bailout ended up creating the precise scenario that it was supposed to avoid, i.e., damage Ireland?s creditworthiness.
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.
Acharya and his co-authors argue that taxpayers also pay a long-run cost for such bailouts. National governments would attempt to recoup the cost of the bailout by levying excessive taxes on the non-financial sector in future or by using other distortionary measures. However, such distortions would blunt the non-financial sector?s incentives to invest and drag down economic growth to a trickle.
The short- and long-run cost of these bailouts sends a clear message to national governments: look before you leap into a bailout!
The author is assistant professor of finance at ISB, Hyderabad