We show that financial sector bailouts and sovereign credit risk are intimately linked. A bailout benefits the economy by ameliorating the under-investment problem of the financial sector. However, increasing taxation of the non-financial sector to fund the bailout may be inefficient since it weakens its incentive to invest, decreasing growth. Instead, the sovereign may choose to fund the bailout by diluting existing government bondholders, resulting in a deterioration of the sovereign's creditworthiness. This deterioration feeds back to the financial sector, reducing the value of its guarantees and existing bond holdings as well as increasing its sensitivity to future sovereign shocks. We provide empirical evidence for this two-way feedback between financial and sovereign credit risk using data on the credit default swaps (CDS) of the Eurozone countries and their banks for 2007-11. We show that the announcement of financial sector bailouts was associated with an immediate, unprecedented widening of sovereign CDS spreads and narrowing of bank CDS spreads; however, post-bailouts there emerged a significant co-movement between bank CDS and sovereign CDS, even after controlling for banks' equity performance, the latter being consistent with an effect of the quality of sovereign guarantees on bank credit risk. * We are grateful to Stijn Claessens, Ilan Kremer,

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We present a new channel for the transmission of monetary policy, the deposits channel. We show that when the Fed funds rate rises, banks widen the spreads they charge on deposits, and deposits flow out of the banking system. We present a model where this is due to market power in deposit markets. Consistent with the market power mechanism, deposit spreads increase more and deposits flow out more in concentrated markets. This is true even when we control for lending opportunities by only comparing different branches of the same bank. Since deposits are the main source of liquid assets for households, the deposits channel can explain the observed strong relationship between the liquidity premium and the Fed funds rate. Since deposits are also a uniquely stable funding source for banks, the deposits channel impacts bank lending. When the Fed funds rate rises, banks that raise deposits in concentrated markets contract their lending by more than other banks. Our estimates imply that the deposits channel can account for the entire transmission of monetary policy through bank balance sheets.

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Understanding why banks borrow from the Lender of Last Resort (LOLR) during a financial crisis is crucial to understanding the macroeconomic impact of such largescale interventions. We document a strong divergence among banks' take-up of LOLR assistance during the financial crisis in the euro area, as banks which borrowed heavily also used increasingly risky collateral. We propose four explanations for this divergence:(1) illiquidity, (2) risk-shifting, (3) political economy, and (4) differences in banks' private valuations. We test these explanations using proprietary data on all central bank borrowing and collateral pledged in the euro area from 2008 to 2011, together with holdings data from the European bank stress tests. Our results strongly support the risk-shifting explanation. We find it both in the financially-distressed countries, where illiquidity and political economy are also at work, and in the non-distressed countries, where it appears to be the main driver of differences in bank's behavior.