Risky Bank Guarantees (with T. Makinen and L. Sarno)

Abstract:
We show that when a sovereign grants a bank a risky guarantee, that is one which will not be honored with certainty, the risk premium on the claims of the guaranteed bank can be larger than that on the claims of an unguaranteed bank. This is because, even though a guaranteed claim yields a higher payoff in all states of the world than an unguaranteed claim, the guarantee can render the payoff more procyclical, thus providing poor insurance in bad states of the world. The predictions of our theoretical model are largely supported by the data; using standard portfolio-sort techniques, we find a statistically and economically significant risk premium associated with the guarantee. Taken together, our findings uncover novel evidence on the bank-sovereign nexus.