Bank Risk, Bank Bailouts and Sovereign Capacity During a Financial Crisis: A Cross-Country Analysis

Abstract

This paper analyzes the competitive effects of government bailout expectations on bank risk using a sample of banks in Organisation for Economic Co-operation and Development countries from 2005 to 2015. We verify that, ordinarily, the bailout expectations of a given bank increase its competitors’ risk. During a crisis, however, this effect is mitigated, ie, banks with more protected competitors reduce their risk in relation to banks with less protected competitors. We also show that in countries with higher sovereign risk (a lower capacity to bail out banks), the effect of competitors’ protection on bank risk during a crisis is smaller, which is consistent with the idea that bailing out protected banks becomes less credible in these countries during turbulent times. Taken together, these results suggest that the bailout expectations of competing banks put pressure on bank margins and lead to more risk in normal times, whereas market-disciplining forces become stronger for banks with protected competitors during a crisis, forcing them to reduce risks.