Via VOX EU

As the global economy descends into recession, there are rising worries about the ability of banking systems across the globe to withstand the sharp, and synchronized, downturn. Shrinking capital buffers due to rising default risks could lead to a pro-cyclical credit crunch, which has motivated supervisors in Europe and elsewhere to offer capital relief, and international bodies to delay the implementation of outstanding regulatory reforms (ECB 2020, Basel Committee 2020). A healthy and efficient banking sector is critical for a swift economic recovery after the crisis. However, further action might be needed if losses accumulate on banks’ balance sheets or banks lose access to market funding, causing widespread bank distress. Over the past decade, countries across the globe have established or upgraded their legal and regulatory frameworks for resolving banks in distress. The question is whether these frameworks are also fit for purpose in a systemic banking crisis.

In recent work, we have compiled a database on resolution frameworks across 22 member countries of the Financial Stability Board (FSB) and assess how the systemic risk contributions of banks in these countries change if the global economy or financial system is hit by system-wide shocks (Beck et al. 2020).

How to resolve banks

The multiple bank failures during the Global Crisis have reinforced the view that the general corporate insolvency framework is inappropriate for banks (Cihak and Nier 2009). It does not take into account the impact of a bank failure on the stability of the overall financial system and the real economy, and it is too slow to deal with fast-evolving distress situations in the financial system. A special bank resolution framework is generally viewed as being better suited in such situations as it takes spill-overs and macroprudential concerns into account by taking a systemic perspective. It also allows for much quicker intervention and resolution.  Among the critical components of a comprehensive bank resolution regime are:

  • A designated resolution authority, which can intervene and resolve failing banks without having to wait for court decisions;
  • Wide-spread powers for this resolution authority, including the power to remove and replace bank management and override shareholder rights;
  • A wide range of resolution tools, including a transfer or sale of assets and liabilities, the establishment of a bridge institution or of an asset management company;
  • The possibility to bail-in junior bondholders and a restriction on taxpayer support before such a bail-in.

In 2011, the FSB issued a set of 12 key attributes of an effective bank resolution framework, which also served as a blueprint for the Bank Recovery and Resolution Directive (BRRD) of the EU.

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Bank resolution across the globe

Based on these key attributes, we derive 22 specific variables relating to different components of an effective bank resolution framework and document the development of bank resolution frameworks across 22 member countries of the FSB between 2000 and 2015 (Figure 1).

Figure 1 Resolution index over time, across different country (groups)

While we see a general trend of countries adopting more comprehensive resolution frameworks over time, there are some noteworthy observations:

  • There is substantial variation in the implementation of resolution features across countries.
  • The US had an already comprehensive bank resolution framework in the early 2000s, mostly due to the reforms implemented after the S&L crisis of the late 1980s and early 1990s. Further reforms were introduced under the Dodd-Frank Act in 2010.
  • European countries were lagging behind, with major reforms only introduced in the wake of the Global Crisis. The Bank Recovery and Resolution Directive (BRRD) of 2014 subsequently harmonised the frameworks across the EU.

Bank resolution frameworks in theory and practice

Allowing early intervention and the write-down of shareholder and junior debtholder claims helps not only minimise the damage of bank failures for the remaining banking system and the real economy, it might also reduce banks’ incentives to take aggressive risks that might result in bank failures. Assessments of recent bank resolutions in Europe have pointed to successful cases, such as the resolution of the Portuguese Banco de Espírito Santo (Beck et al. 2020, World Bank 2016).

Theory is split, however, on the effects of resolution regimes during system-wide shocks, such as the one we are currently experiencing. On the one hand, a lower likelihood of bailouts can increase market discipline and reduce over-leveraging (Repullo 2005, Farhi and Tirole 2012). On the other hand, a rule-based system that ties regulators’ hands can result in bank runs and contagion if regulators have private information about bank performance and can destabilize the financial system in the middle of a crisis, through direct interlinkages of banks holding each other’s claims, as well as information effects and sudden reassessment of bank risk (Walther and White 2020, Eisert and Eufinger 2018).

We test these different hypotheses by gauging the change in systemic risk contributions of 760 banks, as measured by the change in the conditional value at risk (DCoVaR, Adrian and Brunnermeier 2016) after seven different shocks to the financial system, considered to be unexpected and exogenous for individual banks. We compare the changes in banks’ DCoVaR across countries and years with different bank resolution frameworks. The analysed events include negative system-wide shocks (such as Lehman Brothers’ collapse in 2008) and positive system-wide shocks (such as Mario Draghi’s ‘whatever it takes’ speech in 2012).

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Our results show:

  • Systemic risk increases more after negative system-wide shocks in countries with more comprehensive resolution frameworks, while it decreases more after positive shocks, suggesting that more comprehensive resolution regimes amplify rather than mitigate shocks during crisis times.
  • This result is robust to excluding global systemically important banks (G-SIBs), weighing regressions by the number of banks per country, controlling for the initial level of systemic risk contribution of banks, and controlling for the endogeneity of resolution reforms.
  • Disentangling the effect of different components, we find that it is primarily driven by the bail-in framework and resolution authorities’ ability to manage losses and operate banks. Given that no country had a bail-in framework in place during the early events of our study and few during the last events, we interpret the results as suggesting that the absence of a bail-in framework does not exacerbate system-wide shocks
  • Having a designated resolution authority seems to be a mitigating factor of systemic risk during negative system-wide shocks.
  • We do not find an exacerbating effect during times of bank-specific shocks, such as the trading losses of Société Générale in 2008, the resolution of the Portuguese Banco Espírito Santo in 2014, or the announcement of losses at Deutsche Bank in 2016.

Figure 2 shows the dynamics of systemic risk after a negative system-wide event, the default of Lehman Brothers. We split our sample into banks in countries with an above-median (red) and below-median (blue) value of an index measuring the comprehensiveness of bank resolution regimes. Banks in countries with above-median regimes have, on average, higher DCoVaR, but with a parallel trend between the two groups before Lehman Brothers’ collapse. After the event, we see a higher increase in DCoVaR among banks in countries with more comprehensive resolution regimes.

Figure 2 DCoVaR around Lehman Brothers’ failure

Note: Panel A represents the average DCoVaR of banks in countries with below-median (blue) and with above-median resolution (red) index. Panel B represents the difference between average DCoVaR of banks in countries with below-median (blue) and with above-median resolution index (red) from Panel A.

Conclusion

Overall, our results lend support to theories that focus on the negative stability effects of bank resolution regimes designed for idiosyncratic bank failures during system-wide shocks. While resolution regimes seem fit for purpose for resolution of individual banks, they may be counterproductive in systemic distress situations.

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Our findings do not question the benefits of bank resolution regimes in general. They rather suggest that more efforts are needed to improve the macroprudential scope of bank resolution regimes to be able to contain systemic risk in a crisis.  One possibility, as suggested by IMF (2018) in its assessment of the Eurozone’s financial safety net, is to introduce a financial stability exemption for bail-in rules during systemic distress periods and allow for government recapitalisation without bail-in. Clear governance structures and strict conditions are necessary for such an exemption, though. Another policy conclusion from our findings is that systemic crisis preparation and crisis management have to take a more prominent role within financial safety nets.

Authors’ note: This column (and the underlying paper) should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the author, who wrote the paper before becoming an ECB Executive Board member in January 2020, and do not necessarily reflect those of the ECB.  

References

Adrian, T, M Brunnermeier (2016), “CoVaR”, American Economic Review 106(7): 1705-1741.

Basel Committee (2020), Governors and Heads of Supervision announce deferral of Basel III implementation to increase operational capacity of banks and supervisors to respond to Covid-19, 27 March.

Beck, T, S Da-Rocha-Lopes, A Silva, (2020), “Sharing the Pain? Credit Supply and Real Effects of Bank Bail-ins”, Review of Financial Studies, forthcoming.

Beck, T, D Radev, I Schnabel (2020), “Bank Resolution Regimes and Systemic Risk”, CEPR Discussion Paper 14724.

Cihak, M, E Nier (2009), “The Need for Special Resolution Regimes for Financial Institutions – The Case of the European Union”, IMF Working Paper No. 09/200.

Eisert, T, C Eufinger (2018), “Interbank Networks and Backdoor Bailouts: Benefiting from Other Banks’ Government Guarantees”, Management Science 65: 3673-3693.

European Central Bank (2020), ECB asks banks not to pay dividends until at least October 2020, 27 March.

Farhi, E, J Tirole (2012), “Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts”, American Economic Review 102: 60-93.

IMF (2018), “Euro Area Policies: Financial Sector Assessment Program – Technical Note – Bank Resolution and Crisis Management”, IMF Country Report No. 18/232.

Repullo, R (2005), “Liquidity, Risk Taking, and the Lender of Last Resort”, International Journal of Central Banking 1: 470-80.

Walther, A, L White (2020), “Bail-ins and bail-outs in bank resolution”, Review of Financial Studies, forthcoming.

World Bank (2016), “Bank resolution and bail-in in the EU: selected case studies pre and post BRRD”, Working Paper 112265, World Bank.