This paper explores the relationship between financial sector bailouts and sovereign credit risk. It shows that financial sector bailouts can alleviate under-investment problems in the financial sector but may also lead to a deterioration in the sovereign's creditworthiness. This deterioration can feed back onto the financial sector, reducing the value of its guarantees and existing bond holdings and increasing its sensitivity to future sovereign shocks. The authors 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 for 2007-10. They 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, which is consistent with an effect of the quality of sovereign guarantees on bank credit risk. The paper also discusses the case of Ireland, where the government's bailout of its banks led to a significant increase in sovereign credit risk. The authors argue that bailouts can be a pyrrhic victory because they may lead to higher sovereign credit risk and increased taxpayer costs. The paper develops a theoretical model and provides empirical evidence that help understand this phenomenon. The model shows that the government can finance a bailout through both increased taxation and via dilution of existing government debt-holders. The bailout is beneficial; it alleviates a distortion in the provision of financial services. However, both financing channels are costly. Increased taxation reduces the non-financial sector's incentives to invest. When the optimal bailout is large this implies that dilution can become a relatively attractive option, even though it leads to deterioration in the sovereign's creditworthiness. Finally, the paper asks whether there is also feedback going in the other direction—does sovereign credit risk feedback on to the financial sector? The authors explain—and verify empirically—that such a feedback is indeed present, due to the financial sector's implicit and explicit guarantees and holdings of sovereign bonds.This paper explores the relationship between financial sector bailouts and sovereign credit risk. It shows that financial sector bailouts can alleviate under-investment problems in the financial sector but may also lead to a deterioration in the sovereign's creditworthiness. This deterioration can feed back onto the financial sector, reducing the value of its guarantees and existing bond holdings and increasing its sensitivity to future sovereign shocks. The authors 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 for 2007-10. They 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, which is consistent with an effect of the quality of sovereign guarantees on bank credit risk. The paper also discusses the case of Ireland, where the government's bailout of its banks led to a significant increase in sovereign credit risk. The authors argue that bailouts can be a pyrrhic victory because they may lead to higher sovereign credit risk and increased taxpayer costs. The paper develops a theoretical model and provides empirical evidence that help understand this phenomenon. The model shows that the government can finance a bailout through both increased taxation and via dilution of existing government debt-holders. The bailout is beneficial; it alleviates a distortion in the provision of financial services. However, both financing channels are costly. Increased taxation reduces the non-financial sector's incentives to invest. When the optimal bailout is large this implies that dilution can become a relatively attractive option, even though it leads to deterioration in the sovereign's creditworthiness. Finally, the paper asks whether there is also feedback going in the other direction—does sovereign credit risk feedback on to the financial sector? The authors explain—and verify empirically—that such a feedback is indeed present, due to the financial sector's implicit and explicit guarantees and holdings of sovereign bonds.