Moral Hazard and Bail‐Out in Fiscal Federations: Evidence for the German Länder

Kirsten H. Heppke‐Falk and Guntram Wolff

ULB Institutional Repository from ULB -- Universite Libre de Bruxelles

Abstract: SUMMARY We identify investor moral hazard in the German fiscal federation. Our identification strategy is based on a variable, which was used by the German Federal Constitutional Court as an indicator to determine eligibility of two German states (Länder) to a bail‐out, the interest payments‐to‐revenue ratio. While risk premia measured in the German sub‐national bond market react significantly to the relative debt level of a state (Land), we also find that a larger interest payments‐to‐revenue ratio counter‐intuitively lowers risk premia significantly. Furthermore, with increasing values the risk premia decrease more strongly. This is evidence of investor moral hazard, because a larger indicator value increases the likelihood of receiving a bail‐out payment. Our findings are robust to a variety of sample changes. In addition, we provide a case study of the recent Federal Constitutional Court ruling on the Land Berlin, which had filed for additional federal funds. The negative response of the court did not lead to a change in financial markets' bail‐out expectations. In sum, our results indicate significant investor moral hazard in the sub‐national German bond market.

Date: 2008-08
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Published in: Kyklos (2008) v.61 n° 3,p.425-446

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Persistent link: https://EconPapers.repec.org/RePEc:ulb:ulbeco:2013/386960

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