A tale of two overhangs: the nexus of financial sector and sovereign credit risks

There has emerged in the Western economies a strong nexus between the credit risks of fi nancial sectors and their sovereigns. We argue that this phenomenon can be understood in the context of two debt overhang problems: one affecting the fi nancial sector due to its under-capitalisation following the crisis of 2007-08; the second, affecting the non-fi nancial sector, whose incentives are crowded out by high sovereign debt and anticipated future taxes. While the desire to resolve the fi nancial sector overhang may make bailouts tempting, they raise the risk of exacerbating the overhang related to sovereign debt. Conversely, reduction of growth prospects due to sovereign debt overhang can make the fi nancial sector riskier as it is highly exposed to sovereign debt both through direct holdings and indirectly through implicit government guarantees. We provide evidence on this important nexus, based on our ongoing research that exploits data on European bank and sovereign credit risks. VIRAL V. ACHARYA Professor of Finance New York University Stern School of Business ITAMAR DRECHSLER Assistant Professor of Finance New York University Stern School of Business PHILIPP SCHNABL Assistant Professor of Finance New York University Stern School of Business