The European Bank Recovery and Resolution Directive: A market assessment

Abstract

This paper provides evidence of the impact of the new European bank resolution regime on the sovereign-bank nexus. The implementation of the Bank Recovery and Resolution Directive (BRRD) is considered as an exogenous shock which provides the setting for a natural experiment. This investigation tests the financial markets’ perception of the effectiveness of the new rules in weakening the tight interconnectedness between sovereign and bank risk. A Difference-in-Differences (DiD) approach is adopted, building evidence from the Credit Default Swap (CDS) market for banks and non-financial corporates over the period 2011-18. The main findings do not indicate a significant weakening in the interaction between bank and sovereign CDS spreads, compared to the corresponding evidence for the non-financial corporate sector. An overall narrowing of the gap between bank and sovereign risk occurs, which initially implies a lack of credibility of the BRRD in financial markets. However, substantial cross-country variations are identified, particularly for Italy and non-euro area countries. These insights make a significant contribution to the policy debate on effective regulation of the sovereign-bank nexus, in the light of recent developments in the EU post-crisis reform agenda.