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.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
The bail-in rule is one of the resolution tools in the legislative proposal for bank recovery and resolution adopted by the Commission on 6 June 2012. More details available at http://ec.europa.eu/internal_market/bank/crisis_management/.
The current model can be extended by a more refined estimate of the actual impact of public support on the public deficit. Moreover, the estimated effect on the sovereign risk premium can be enhanced by developing a more forward-looking model that takes into account deficit and debt projections.
Basel II minimum capital requirement is equal to 8 % of RWA.
This required running up to 2 000 000 simulations.
This choice is in line with James (1991).
This hypothesis does not influence results, as explained in Cannas et al. (2012).
The European Commission DG Competition database about State aid decisions authorised by the European Commission during the period 2008-2012 lists the measures approved to deal with the financial crisis and its consequences. An explanatory memo is available at http://europa.eu/rapid/press-release_MEMO-12-665_en.htm.
We do not consider the existence of regulatory tools such as deposit guarantee schemes that could postpone direct public interventions. Neither is the existence of resolution funds explicitly taken into account. Nevertheless, we can assume that resolution funds are regulatory tools that stop contagion between banks to prevent a systemic banking crisis. To this extent, results obtained in a no-contagion context should be considered as having been obtained in a regulatory framework with an efficient resolution fund.
Total assets in the table. We remind that capital requirements are calculated not on total assets but on RWAs.
References
Acharya, V.V., Drechsler, I., & Schnabl P. (2011). A phyrrhic victory? bank bailouts and sovereign credit risk. CEPR Discussion Paper 8679.
Alexander, V., & Anker, P. (1997). Fiscal discipline and the question of convergence of national interest rates in the European union. Open Economies Review, 8, 335–352.
Bank of England (2010). Financial Stability Report. Issue No. 27.
Basel Committee on Banking Supervision, The transmission channels between the financial and real sectors: a critical survey of the literature. Issue No. 27 (2010).
Bernoth, K., von Hagen, J., & Schuknecht, L. (2004). Sovereign risk premia in the European government bond market. European Central Bank Working Paper Series No. 369.
Bernoth, K., & Erdogan, B. (2010). Sovereign bond yield spreads: a time-varying coefficient approach. DIW, mimeo.
Cannas, G., De Lisa, R., Galliani, C. & Zedda, S. (2012). The role of contagion in financial crises: an uncertainty test on Interbank patterns. Eur Scientific And Technical Research Series, European Commission Luxembourg, Publication Office of the European Union. ISBN: 978-92-79-23849-9.
Cecchetti, S.G., Kohler, M., & Upper, C. (2009). Financial crises and economic activity. Working Paper, BIS.
Codogno, L., Favero, C.A., & Missale, A. (2003). Yield spreads on EMU government bonds. Economic Policy 37.
Committee on the global financial system, the impact of sovereign credit risk on bank funding conditions. BIS CGFS Paper No. 43 (2011).
Copeland, L., & Jones, S.-A. (2001). Default probabilities of European sovereign debt: market-based estimates. Applied Economics Letters, 8(5), 321–324.
De Lisa, R., Zedda, S., Vallascas, F., Campolongo, F., & Marchesi, M. (2011). Modelling deposit insurance scheme losses in a basel 2 framework. Journal of Financial Services Research, 40(3), 123–141.
Drehmann, M., & Tarashev, N. (2013). Measuring the systemic importance of interconnected banks. Journal of Financial Intermediation, 22, 586–607.
Edwards, S. (1986). The pricing of bonds and bank loans in international markets: an empirical analysis of developing countries’ Foreign borrowing. NBER Working Paper No. 1689.
Elsinger, H., Lehar, A., & Summer, M. (2006). Using market information for banking system risk assessment. International Journal of Central Banking, 2, 137–165.
Eschenbach F., & Schuknecht L. (2002). The fiscal costs of financial instability revisited. European Central Bank Working Paper No. 191.
European Commission, Directorate-General for Economic and Financial Affairs, Public finances in EMU 2011. European Economy 3 (2011). Available at http://ec.europa.eu/economy_finance/publications/european_economy/2011/ee3_en.htm
Furceri D., Zdzienicka A., The consequences of banking crises for public debt. OECD Economics Department Working Papers No. 801 (2010). Available at http://dx.doi.org/10.1787/5km7v02j85zp-en
James, C. (1991). The loss realised in bank failures. The Journal of Finance, 46, 1223–1242.
Laeven L., & Valencia F. (2010). Systemic banking crises: a new database. IMF Working Paper No. 08–224.
Lemmen, J., & Goodhart, C. (1999). Credit risk and European government bond markets: a panel data econometric analysis. Eastern Economic Journal, 25, 1.
Lønning I., Default premia on European government debt, Weltwirtschaftliches Archive, 136(2):259–283 (2000).
Masselink M., & van den Noord P. (2009). The global financial crisis and its effects on the Netherlands. ECFIN Country Focus No. 06–10.
Reinhart, C., & Rogoff, K. (2008). This time is different: eight centuries of financial folly. New Jersey: Princeton University Press.
Reinhart, C., & Rogoff, K. (2008b). Is the 2007 US Sub-Prime Financial crisis so different? an international historical comparison. NBER Working Paper No. 13761.
Reinhart, C., & Rogoff, K. (2009). The aftermath of financial crises. American Economic Review, 99(2), 466–472.
Upper, C. (2011). Simulation methods to assess the danger of contagion in interbank markets. Journal of Financial Stability, 7(3), 111–125.
Author information
Authors and Affiliations
Corresponding author
Additional information
The content of this article does not reflect the official opinion of the European Commission. Responsibility for the information and views expressed therein lies entirely with the authors.
Rights and permissions
About this article
Cite this article
Galliani, C., Zedda, S. Will the Bail-in Break the Vicious Circle Between Banks and their Sovereign?. Comput Econ 45, 597–614 (2015). https://doi.org/10.1007/s10614-014-9436-9
Accepted:
Published:
Issue Date:
DOI: https://doi.org/10.1007/s10614-014-9436-9