Implementing a European Bail-In Regime: Do BRRD and SRM-R Effectively Eliminate Implicit Government Guarantees in the European Banking Sector? Sascha Hahn* Allianz Endowed Chair of Finance WHU - Otto Beisheim School of Management Burgplatz 2, 56179 Vallendar, Germany Telephone: +49 151 537 25 333 E-mail: [email protected] Paul P. Momtaz Department of Finance UCLA Anderson School of Management 110 Westwood Plaza, Los Angeles, CA 90095 Telephone: +1 424 387 9259 E-mail: [email protected] Axel Wieandt Finance and Accounting Group WHU - Otto Beisheim School of Management Burgplatz 2, 56179 Vallendar, Germany Telephone: +49 261 65 09-0 E-mail: [email protected] This version: October 7, 2020 __________________________ *Corresponding author. We thank Holger Mueller (NYU Stern), Ingo Walter (NYU Stern), Sebastian Schich (OECD), and Alexander Schäfer (German Council of Economic Experts) for helpful discussions. We also thank seminar participants at WHU Otto Beisheim School for Management for valuable comments. This research did not receive any specific grant from funding agencies in the public, commercial, or not- for-profit sectors. Electronic copy available at: https://ssrn.com/abstract=3645298 Implementing a European Bail-In Regime: Do BRRD and SRM-R Effectively Eliminate Implicit Government Guarantees in the European Banking Sector? Abstract This paper assesses the market effects of regulatory events associated with the implementation of a bail-in regime for failing European banks. The bail-in regime was designed to make banks efficiently resolvable in order to abolish Implicit Government Guarantees (IGGs). We use a seemingly-unrelated-regressions framework to estimate the effects on CDS spreads and equity returns of key events associated with the two cornerstones of the European bail-in regime, the Bank Recovery & Resolution Directive (BRRD) and the Single Resolution Mechanism Regulation (SRM-R), and other relevant events. Contrary to the regulations’ objectives, we find that regulatory events associated with the implementation of BRRD and SRM-R led to tighter CDS spreads and higher equity returns over the 2009-2017 period. The pattern varies with bank heterogeneity and is particularly pronounced for G-SIBs, suggesting that the regime does not effectively solve the systemic problem of bailout expectations in the European banking sector. JEL Classification: E58, G18, G21, G23, G33, G38 Keywords: Bail-In, Implicit Government Guarantee, European Banking Regulation, Too-Big-to- Fail, Global Systemically Important Bank (G-SIB), Bank Recovery & Resolution Directive (BRRD), Single Resolution Mechanism (SRM) Electronic copy available at: https://ssrn.com/abstract=3645298 1. Introduction “Never again” was the collective determination of governments after being forced to bail out banking institutions and provide guarantees and capital to avert systemic collapse as a result of the global financial crisis of 2007/08.1 Since then, the responsible international regulatory bodies have developed new regulatory measures consisting of enhanced supervision, capital surcharges, and resolution regimes specifically for banks that would pose high risks to the financial system if they were to fail.2 More than ten years after the crisis, Elke König, chair of the Single Resolution Board (SRB)3, again reiterated the common objective to the European Council that taxpayers should “never again” have to foot the bill for a bank bailout. The negative implications of Implicit Government Guarantees (IGG), such as excessive risk-taking and the misallocation of bank resources, as well as the moral hazard affecting banks identified as Too Big To Fail (TBTF) led to the global financial crisis of 2007 and renewed debate over government intervention in the financial sector (e.g., Barth and Seckinger, 2018; Moenninghoff et al., 2015). During this crisis, implicit guarantees were made explicit.4 With the exception of Lehman Brothers,5 all large financial institutions, including banks and non-banks, 1 G-20 meeting in Pittsburgh (2009) and the White House “Remarks by the President at G20 Closing Press Conference” (Sept 25, 2009) 2 Affected banks must adhere to this regulation in addition to Basel III standards, which include increased capital and liquidity requirements. See also Moenninghoff, Ongena and Wieandt (2015) 3 The Single Resolution Board (SRB), the highest authority for bank resolution in Europe, was established in 2014 by Regulation (EU) No 806/2014 on the Single Resolution Mechanism (SRM Regulation) and began work on 1 January 2015. It became fully responsible for resolution on 1 January 2016 and was henceforth the resolution authority for around 143 significant banking groups as well as any cross-border banking group established within participating Member States. 4 The use of public funds in this sector increased dramatically between 2008 and 2013. The interventions took various forms, ranging from recapitalization to loans and explicit government guarantees. 5 Lehman Brothers filed for Chapter 11 bankruptcy protection on Monday, September 15, 2008. As reported by Tiffany Kary in Bloomberg News, reports filed with the U.S. Bankruptcy Court, Southern District of New York (Manhattan) on September 16 indicated that JPMorgan Chase & Co. provided Lehman Brothers with a total of $138 billion in "Federal Reserve-backed advances", including $87 billion on September 15 and $51 billion on September 16 (“JPMorgan Gave Lehman $138 Billion 1 Electronic copy available at: https://ssrn.com/abstract=3645298 that encountered difficulties were bailed out,6 i.e., they received support by the government. Arguably, this government support may have been needed to avoid financial contagion within a closely interconnected banking system, but there is an inherent risk of moral hazard when financial institutions and their shareholders can expect to be bailed out by governments using public funds. Moreover, in the Euro area, the 2008 bailout caused what became the nexus of the crisis: the fatal doom loop between bank and sovereign creditworthiness (e.g., Acharya et al., 2014). In response to the financial crisis, international regulatory bodies developed new mandatory regulatory measures consisting of enhanced supervision, capital surcharges, and the establishment of resolution regimes specifically for banks that would pose high risks to the financial system if they were to fail. 7 In Europe, where most countries lacked a resolution framework before the crisis, policymakers designed a completely new regulatory framework. In addition, the EU established the Banking Union, which contains three pillars: the Single Supervisory Mechanism (SSM), the Single Resolution Mechanism (SRM), and a planned common and harmonized scheme to protect deposits by EU citizens. As part of the SRM, the Single Resolution Board (SRB) is governed by the provisions of the Bank Recovery and Resolution Directive (BRRD)8 and the Single Resolution Mechanism Regulation (SRM-R)9. The recent after Bankruptcy,” by Tiffany Kary and Chris Scinta, Bloomberg News, November 11, 2011; “Lehman Brothers files for bankruptcy”, Financial Times, September 16, 2008). 6 This led, among others, to a substantial disbursement for many governments and threatened the solvency of various European countries, such as Ireland and Spain. 7 Existing bank resolution mechanisms were overhauled in many countries following the adoption in 2011 of the Financial Stability Board (FSB)’s Key Attributes for Effective Resolution Regimes. 8 Bank Recovery and Resolution Directive (2014/59/EU) (BRRD) was established by European Directive and therefore, due to national implementation for all SSM member states, acts as a recovery and resolution framework for EU credit institutions and investment firms. It contains requirements relating to recovery and resolution plans, early supervisory interventions and the resolution of firms, including the introduction of a bail-in tool. European Directives such as the BRRD have to be implemented nationally by each member state of the European Union and are not implemented on a harmonized basis at the same time. 9 Single Resolution Mechanism (SRM) applying to banks headquartered in EU member states participating in the single supervisory mechanism (SSM). The SRM, which was established by the SRM Regulation (806/2014) (SRM-R), forms part of the European banking union. 2 Electronic copy available at: https://ssrn.com/abstract=3645298 Banking Package10 is designed to improve the framework for an orderly resolution of financial institutions when they fail or when there are signs of likely failure. The shortcomings of the 2018 Banking Package include the lack of uniform implementation across EU member states and exceptions allowing member states to influence how bank failure is handled. A specific major legal loophole is the tool of “precautionary recapitalization”11. Recent bank failures in Italy12 illustrate that banks can still negotiate with national governments and the competent regulatory agency to avoid complete bail-in if such avoidance is of individual, political and/or national interest. As long as exceptions to the European bail-in regime are permitted, IGGs may not be sufficiently reduced or eliminated. The purpose of our paper is to assess how effectively the European bail-in regime eliminates or at least reduces IGGs within the European banking sector. An effective regime would widen CDS spreads and reduce equity returns as a consequence of an increased probability of bank failure without bail-out intervention