Will the Bail-in Break the Vicious Circle Between Banks and their Sovereign?

Abstract

In December 2013 the European Commissioner Barnier, presenting the Single Resolution Mechanism for the resolution and recovery of banking crises, said it will "break the vicious circle between banks and their sovereigns". But is there any vicious circle? And if so, will resolution tools be able to break it? In literature, the circular nature of the relationship between banking and sovereign debt crises has not yet been properly addressed. Indeed, most papers exclusively focus on one channel of transmission, either quantifying the effects that banking crises have on public finances or analyzing when banking crises may cause sovereign debt crises (or vice-versa). In this paper we propose a computational approach to quantify the effects of this circular relationship and to highlight how sovereign and bank riskiness may increase because of their interconnection. We quantify the effects of bank distress on the banking system itself, passing through the higher public deficit induced by State support, and the subsequent haircut in government bonds. We then test the effectiveness of the bail-in tool proposed in the Single Resolution Mechanism context. The method is tested on four European countries. Results show that, while limited crises tend to be absorbed by the system, serious crises tend to exacerbate at each turn, so that it becomes impossible to stop them without external intervention. Moreover, results show that a bail-in of 8 % of total bank balance sheet can be really effective in breaking the vicious circle and preventing contagion between banks and public finances. This finding supports the bail-in as a valid instrument to avoid taxpayers paying the bill of banking crises.