Does BRRD mitigate the bank-to-sovereign risk channel?

Area of Science:

• Financial Economics
• Banking Regulation
• Sovereign Debt

Background:

• The interconnectedness of banks and sovereigns poses systemic risks, particularly evident during the Euro Area sovereign debt crisis.
• The Bank Recovery and Resolution Directive (BRRD) was implemented to enhance financial stability by providing resolution frameworks for failing banks.
• Assessing the effectiveness of regulatory interventions like the BRRD in decoupling bank and sovereign credit risk is crucial for financial stability.

Purpose of the Study:

• To investigate the effectiveness of the BRRD in mitigating bank-to-sovereign credit risk transmission.
• To determine if financial markets perceive the BRRD bail-in framework as credible.
• To analyze the impact of the BRRD on bank-sovereign risk linkages, especially in peripheral Euro Area countries.

Main Methods:

• Utilizing Credit Default Swap (CDS) spreads to measure bank and sovereign credit risk for 43 banks across 8 Euro Area countries (2009-2020).
• Employing a novel approach using bank earnings announcements to identify exogenous shocks to bank credit risk.
• Comparing bank-to-sovereign risk transmission before and during the BRRD era.

Main Results:

• Bank-to-sovereign risk transmission significantly diminished following the introduction of the BRRD.
• The reduction in risk transmission was most pronounced in peripheral Euro Area countries like Italy and Spain.
• The observed reduction is linked to the BRRD's parliamentary approval, not the ECB's OMT program or specific bail-in/bailout events.
• Global Systemically Important Banks (G-SIBs) showed the most significant reduction in risk transmission, highlighting the role of Basel III capital buffers.

Conclusions:

• The BRRD appears to be effective in reducing bank-to-sovereign credit risk transmission, indicating market confidence in the bail-in framework.
• The BRRD has strengthened financial resilience, particularly in countries with historically strong bank-sovereign nexus.
• Enhanced capital requirements for G-SIBs, as per Basel III, further contribute to mitigating systemic risk.