How effective were the ECB’s policies to reduce default risk?

In the aftermath of Lehman Brothers, nearly all Eurozone countries have intervened heavily in the domestic banking sector by providing capital injections, debt or deposit guarantees (see Stolz and Wedow 2010). These measures placed large burdens on public balances. In fact, the correlation between sovereign and bank credit default swap (CDS) spreads in the Eurozone rose from 0.1 to 0.8 between 2007 and 2013 (see Figure 1).

Figure 1. Rolling correlation between sovereign credit risk and bank credit risk in the Eurozone

Note: The figure shows the 200 days rolling correlation between Eurozone sovereign and bank credit default swap spreads.
Source: Datastream.

Once countries tapped their fiscal limits, the ECB stepped in by providing liquidity to banks on a massive scale and by intervening in sovereign debt markets. These events led to an intense debate among policymakers and researchers alike over the merits and risks of these policies. For example, Merler and Pisani-Ferry (2012), Engler and Große Steffen (2014), and Acharya et al. (2015) analyse the effects of bank bailouts. Manganelli (2012) and Eser and Schwaab (2013) evaluate ECB policies.

Based on a recent study (Fratzscher and Rieth 2015), this column addresses two main questions in the debate:

• What are the effects of bank bailouts on credit default risks of banks and sovereigns?
• What are the effects of ECB non-standard policies on these risks?

We use daily credit default swap spreads for 2003-2013 to measure credit default risk of Eurozone sovereigns and banks and collect data on bailout announcements (see CGFS & BIS 2010), non-standard monetary policies by the ECB, and other financial market variables. We then employ a set of structural vector auto regressions (VAR) to obtain empirical estimates of the effects of bank bailout and non-standard monetary policies on sovereign and bank credit default risk.

Bank bailouts and credit default risk

The effects of bank bailouts on sovereign and bank credit risk are not clear a priori. If bailouts are effective in preventing bank runs and improving the outlook for the economy, then they are expected to both lower the risk to the banking sector and to improve sovereign risk. However, if bailouts are so large in magnitude that they imply a major challenge to the sustainability of public debt, then such a transfer of risk can actually worsen sovereign risk, while improving the risk to banks. Indeed, our benchmark estimates suggest that a bailout shock that reduced bank spreads by 100 basis points drove up sovereign spreads by 12 basis points on average.

Non-standard ECB policy and credit risks

Regarding monetary policy, our model reveals substantial differences between the various non-standard measures implemented by the ECB during the European debt crisis. It suggests that the announcement of Outright Monetary Transactions was the most effective measure in lowering default risks in the Eurozone. On average, it reduced sovereign and bank credit default swap spreads by 56 and 34 basis points, respectively. Intuitively, our results show that the effects were stronger in the periphery than in the core and that sovereign spreads decreased by more than bank spreads. For example, Portuguese sovereign and bank spreads declined by 124 and 61 basis points, respectively. Nevertheless, Germany also clearly benefited from the programme as both sovereign and bank spreads decreased (by 8 and 6 basis points, respectively).

The introduction of three-year longer-term refinancing operations can also be regarded as a success, in particular with regard to default risk in the banking sector. Overall, the programme reduced bank CDS spreads by 22 basis points on average. A detailed analysis shows an interesting difference between the initial announcement of the programme and its actual implementation. While the announcement was seen as a disappointment by financial markets, with bank spreads actually increasing, the implementation was effective and ultimately outweighed the adverse initial impact.

Finally, the Securities Market Programme was not successful. We estimate an overall impact of an increase in bank spreads by 129 basis points on average. Again we find an intriguing yet intuitive difference between announcement and implementation effects. The former reduced bank spreads by cumulatively 80 basis points. The latter, however, raised spreads by 209 basis points; reflecting a crowding out of banks’ claims against governments by the ECB.

Concluding remarks

Our estimates suggest that both bank bailout policies and non-standard monetary policies by the ECB had a significant impact on default risks of sovereigns and banks in the Eurozone. The results, however, show that neither of the two policies was unanimously successful. Thus, they entail a note of caution to policymakers that policies which are intended to reduce default risk can have opposite effects if they are not properly designed.

References

Acharya, V V and S Steffen  (2015), “The “greatest” carry trade ever? Understanding eurozone bank risks”, Journal of Financial Economics, pp. 215-236.

Caporin, M, L Pelizzon, F Ravazzolo, and R Rigobon (2013), “Measuring Sovereign Contagion in Europe”, NBER Working Paper 18741.

CGFS, & BIS (2010), “Financial sector rescue plan database, maintained by the BIS, under the auspices of the Committee on the Global Financial System”, 27 October (CGFS).

Engler, P and C Große Steffen (2014), “Sovereign Risk, Interbank Freezes, and Aggregate Fluctuations”, DIW Discussion paper 1436.

Fratzscher, M and M Rieth (2015), “Monetary policy, bank bailouts and the sovereign-bank risk nexus in the euro area”, CEPR Discussion Paper 10370.

Manganelli, S (2012), “The Impact of the Securities Markets Programme”, ECB Research Bulletin 17.

Merler, S and J Pisani-Ferry (2012), “Hazardous tango: sovereign-bank interdependence and financial stability in the euro area”, Financial Stability Review, pp. 201-210.

Stolz, S and M Wedow (2010), “Extraordinary Measures in Extraordinary Times: Public Measures in Support of the Financial Sector in the EU and the United States”, ECB Occasional Paper No. 117, 8 July.

This article is published in collaboration with VoxEU. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Marcel Fratzscher is President of DIW Berlin, a leading research institute and think tank in Europe, Professor of Macroeconomics and Finance at Humboldt-University Berlin, and Member of the Advisory Council of the Ministry of Economy of Germany. Malte Rieth is a research associate at DIW Berlin.

Image: The Euro currency sign is seen next to the European Central Bank (ECB) headquarters in Frankfurt November 6, 2012. REUTERS/Lisi Niesner