Private sector involvement in the resolution of financial crises: How do markets react?

To correct the disincentives of liquidity assistance during financial crises, the official sector attempts to involve the private sector in the resolution of debt crises. This paper empirically tests the reaction of investors to announcements of private sector involvement (PSI). For this purpose, we disentangle shifts in risk premia incorporated in excess returns on emerging market bonds into changes in risk and shifts in the price of risk. A regime-switching ARCH-M model is employed to separate two regimes with respect to the market price of risk. While PSI has no effect on risk, it is shown that the likelihood of switching to a state with a high price of risk rises in response to PSI announcements. Thus, the results indicate that burden sharing was credible and, hence, effective.