Bailouts, Sovereign Risk and Bank Portfolio Choices

Abstract:

I study the role of sovereign risk in determining the effects of expected bailouts on banks' portfolio decisions. Empirically, data on Italian banks show that they decrease lending to firms and increase purchases of government bonds following an increase in the probability of a bailout, if the risk of sovereign default is sufficiently low. The portfolio adjustment goes in the opposite direction when the government default risk is high. To interpret these results, I develop a model in which the relation between the bailout probability and the corresponding payoff to bank owners (“bailout rents”) depends on sovereign risk. The model's predictions are consistent with the key features of the data.