Subnational Credit Risk and Sovereign Bailouts—Who Pays the Premium?
Coauthor(s): Jenkner, Eva, and Zhongjin Lu
Studies have shown that markets may underprice subnational governments’ credit risk on the implicit assumption that the subnational entity would be bailed out by the central government in case of financial difficulties. However, the question of whether a sovereign pays a premium on its own borrowing as a result of (implicitly or explicitly) guaranteeing its sub-entities has yet to be explored. We use an event study approach with separate equations for two levels of government to test for an increase in sovereign risk premia and a simultaneous decrease in subnational risk premia—or a de facto transfer of risk from the latter to the former—as a sovereign bailout is announced. Using daily financial market data for Spain and its autonomous regions from January 2010 to June 2013, we find support for our risk transfer hypothesis. We demonstrate that the sovereign spread increased by around 70 basis points as a result of the central government’s support for fiscally distressed autonomías.
Jenkner, Eva, and Zhongjin Lu "Subnational Credit Risk and Sovereign Bailouts—Who Pays the Premium?." , Columbia Business School, (2013).