Finance: Research, Policy and Anecdotes

We have been working on this paper for quite some time, but the current crisis makes it actually a very timely paper. 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. 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 with Deyan Radev and Isabel Schnabel, 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.

First, based on the FSB’s 12  Key Attributes of an effective bank resolution framework, we construct an index of the comprehensiveness of bank resolution frameworks. 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 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.

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 Financial Crisis. The Bank Recovery and Resolution Directive (BRRD) of 2014 subsequently harmonised the frameworks across the EU.

We then compare the changes in banks’ DCoVaR across 760 banks and 22 countries with different bank resolution frameworks after system-wide shocks, including 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).

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.

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. These theories posit that during systemic bank distress 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. While resolution regimes seem fit for purpose for resolution of individual banks, they may be counterproductive during systemic distress situations.

7. May, 2020