Sovereign fiscal capacity, implicit subsidies, and bank value

Abstract

This study examines how fiscal constraints affect banks' market value in a cross-country sample, using exogenous variations in fiscal constraints based on abnormal military spending. Increased fiscal constraints arising from exogenous spending shocks can affect bank valuation through two different channels with opposing expected effects: spending shocks weaken governments' ability to stabilize the financial system during crises, resulting in lower bank valuation; however, when fiscal constraints are heightened because of positive sector-specific spending shocks (increased military expenditure), corporate earnings—particularly in sectors that are heavily dependent on government contracts—become more predictable, which subsequently reduces banks' earnings volatility, thereby increasing their valuation. We find that fiscal constraints negatively impact banks' valuation, which is consistent with the first channel (i.e., owing to the reduced proportion of banks' value composed by implicit or explicit governmental guarantees). In addition, bank resolution reforms adopted after the global financial crisis attenuate this relationship, but do not completely eliminate it. The sovereign–bank nexus remains relevant and concentrated in large banks. Our inferences provide insights in favor of strengthening bank resolution frameworks, to reduce banks' reliance on governmental funds and ensure bailouts occur only when welfare-enhancing. By limiting expectations of unconditional government support, these regulations may mitigate too-big-to-fail perceptions.