Acharya, Viral V. and Sascha Steffen, “The “Greatest” Carry Trade Ever? Understanding Eurozone Bank Risks,” The American Finance Association 75th Annual Meeting, Boston (2015).
Purpose: To investigate the risks assumed by Eurozone banks as a form of carry trade, where banks loaded positively on GIPSI (Greece, Ireland, Portugal, Spain, and Italy) bonds and negatively on German government bonds.
- Banks’ stock returns were positively correlated with GIPSI bond returns, and negatively correlated with German bond returns, for the period January 2007 to June 2012.
- Banks were effectively financing long-term GIPSI bond holdings with short-term German debt.
- This carry trade behavior was more notable at large banks, banks with lower capital ratios, and banks with riskier asset portfolios.
- Banks increased the magnitude of their carry trade between March and December 2010, ruling out the possibility that they were passively caught up in the crisis.
- Banks’ carry trade exposure was related to actual bond holdings rather than to holdings of other asset classes.
- Both GIPSI and non-GIPSI banks were involved, so the carry trade is not a case of GIPSI banks suffering from the weakness of their home countries.
- Regulatory arbitrage was a likely contributor to the carry trade of both GIPSI and non-GIPSI banks.
- Governments had incentives to maintain the Basel II zero risk-weighting on sovereign bonds so they could continue to borrow.
- Banks with low capital ratios were incentivized to buy these zero risk-weighted sovereign bonds.
- Risk-shifting by GIPSI banks may also have been a contributor to the carry trade of GIPSI banks.
- An Italian bank, say, might have wanted to shift risk to a state of the world where they would be in trouble anyway (an Italian default) by buying Italian bonds.
- Moral hazard may have also played a role, where banks in strong sovereigns might assume the risk of the carry trade with an implicit expectation of being bailed out in a worst-case scenario.
- Moral suasion may have occurred where weak sovereigns convinced their home banks to buy own-sovereign debt.
- U.S. money-market funds played an important role in providing or not providing liquidity to European banks.
- After November 2010, they withdrew 60% of their investment in weakly capitalized banks and doubled their investments in well-capitalized banks.
- Data on stock prices, bond yields, and CDS credit spreads comes from Bloomberg.
- Banks’ portfolio holdings data is from the European Banking Authority (EBA).
- Regress each bank’s daily stock returns on the daily returns of 10-year GIPSI government bonds (all five countries), the daily return on 10-year German government bonds, and the daily return of bank’s home equity market (orthogonalized to the sovereign bond returns of Germany and of the home country).
- estimates each bank’s exposure to Greek sovereign debt, etc.
- is the estimate of each bank’s exposure to German bonds (a negative value indicates the bank is “short” German government debt).
- Estimate the factor loadings quarterly.
- European regulators should not consider the sovereign debt of all Euro countries risk-free (or even high-liquidity).
- ECB lending should probably be used to recapitalize banks rather than to guarantee their debt and encourage them to increase asset exposures.
- While this props up the financial markets, especially in the banks’ home countries (due to home bias), it potentially makes a future sovereign debt crisis even more dangerous.
- When banks hold long-term risky assets and rely on short-term funding, they are likely to encounter liquidity shortages.