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

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Listed:
  • Martien Lamers
  • Thomas Present
  • Nicolas Soenen
  • Rudi Vander Vennet

Abstract

We investigate the effectiveness of the Bank Recovery and Resolution Directive (BRRD) in mitigating the transmission of credit risk from banks to their sovereign, using CDS spreads to capture bank and sovereign credit risk for a sample of 43 banks in 8 Euro Area countries over the period 2009-2020. If the BRRD bail-in framework is credible, changes in bank default risk should not be transmitted to sovereign risk. In a novel approach we use banks’ earnings announcements to identify exogenous shocks to bank credit risk and investigate to what extent bank risk is transmitted to sovereign risk before and during the BRRD era. We find that bank-to-sovereign risk transmission has diminished after the introduction of the BRRD, suggesting that financial markets judge the BRRD framework as credible. The decline in bank-sovereign risk transmission is particularly significant in the periphery Euro Area countries, especially Italy and Spain, where the bank-sovereign nexus was most pronounced during the sovereign debt crisis. We report that the lower bank-to-sovereign credit risk transmission is associated with the parliamentary approval of the BRRD and not with the OMT program launched by the ECB to affect sovereign yield spreads, nor with specific bail-in or bailout cases which occurred during the BRRD era. Finally, we document that the reduction in risk transmission is most pronounced for banks classified as a Global Systemically Important Bank (G-SIB), stressing the importance of additional capital buffers imposed by Basel III.

Suggested Citation

  • Martien Lamers & Thomas Present & Nicolas Soenen & Rudi Vander Vennet, 2023. "Does BRRD mitigate the bank-to-sovereign risk channel?," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium 23/1060, Ghent University, Faculty of Economics and Business Administration.
  • Handle: RePEc:rug:rugwps:23/1060
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    More about this item

    Keywords

    BRRD; bank-sovereign nexus; bank-to-sovereign risk channel; bank earnings announcement; CDS spread;
    All these keywords.

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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