The “Greatest” Carry Trade Ever? Understanding Eurozone Bank Risks

The “Greatest” Carry Trade Ever? 
Understanding Eurozone Bank Risks 
Viral V. Acharya†
 Sascha Steffen‡
March 30, 2013
Abstract
This paper argues that the European banking crisis can in part be explained by a “carry trade”
behavior of banks. Factor loading estimates from multifactor models relating equity returns to
GIPSI (Greece, Ireland, Portugal, Spain and Italy) and German government bond returns suggest
that banks have been long peripheral sovereign bonds funded in short-term wholesale markets, a
position that generated “carry” until the GIPSI bond returns deteriorated significantly inflicting
significant losses on banks. We show that the positive GIPSI factor loadings reflect actual
portfolio holdings of GIPSI bonds in the cross-section of banks; and, the negative German
loading reflects funding risk (flight away from bank funding to German government bonds), a
risk that is increasing in the US money market mutual fund exposures of European banks as well
as various proxies for bank short-term debt. Large banks and banks with low Tier 1 ratios and
high risk-weighted assets had particularly large exposures and even increased their exposures
between the two European stress tests of March and December 2010 taking advantage of a
widening of yield spreads in the sovereign bond market. Over time, there is an increase in “home
bias” – greater exposure of domestic banks to its sovereign’s bonds – which is partly explained
by the European Central Bank funding of these positions. On balance, our results are supportive
of moral hazard in the form of risk-taking by under-capitalized banks to exploit low risk weights
and central-bank funding of risky government bond positions.

Keywords: Sovereign debt crisis, banking crisis, risk-shifting, regulatory arbitrage, home bias

http://www.sascha-steffen.de/uploads/5/9/9/3/5993642/201300330_carry_trade_paper.pdf