Deal! Market reactions to the agreement on the EU Covid-19 recovery fund

In response to the Covid-19 crisis, EU leaders agreed on the creation of a euro750bn recovery fund (the Next Generation EU, NGEU). We investigate the short-term impact of this landmark deal on bank stocks, sovereign credit default swaps (CDS) and bank CDS. First, we find that stock market investors firmly welcomed the agreement as we find sizeable positive abnormal returns in bank stocks as a response to the NGEU proposal by the European Commission. Spreads on sovereign and bank CDS significantly declined, with more pronounced movements for heavily indebted countries and those that strongly advocated the creation of the recovery fund and for the banks located in these economies. Second, we show that banks' sovereign exposures towards other European countries, especially those with weaker financial conditions and limited fiscal capacity, play a key role in driving the strength of the stock market reaction. Overall, financial markets responded positively to the credibility of the NGEU policy as an extraordinary common effort to support the post-Covid-19 recovery and enhance economic growth in the region.