Risky Bank Guarantees (wit h T. Makinen and L. Sarno)
Abstract:
We show that when a sovereign grants a bank a risky guarantee, that is o
ne 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 unguara
nteed bank. This is because, even though a guaranteed claim yields a higher
payoff in all states of the world than an unguaranteed claim, the guarante
e can render the payoff more procyclical, thus providing poor insurance in
bad states of the world. The predictions of our theoretical model are large
ly 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 b
ank-sovereign nexus.