Bail‐in rules and the pricing of Italian bank bonds

AuthorDanilo V. Mascia,Emanuela Giacomini,Fabrizio Crespi
Published date01 November 2019
INTRODUCTION

Since the onset of the Global Financial Crisis a decade ago, many European governments were forced to intervene through capital injections and purchase of toxic assets in order to support their troubled banks (Ammann, Blickle, & Ehmann, ) and, consequently, avoid financial contagion within closely interconnected banking systems (Deutsche Bank, ). Bank resolutions were costly, indeed, during the 2008–2012 period, with public interventions amounting to roughly 600 billion euros (excluding guarantee schemes), that is, 4.6% of the European gross domestic product (GDP) in 2012 (Benczur et al., ). More importantly, because taxpayers’ money was used to manage the crisis of (mostly private) banks, public bailouts were unsustainable from both a financial and a political perspective.

In addition, the expectation of assistance via publicly funded bailouts amplifies moral hazard behavior, leading to excessive risk‐taking in particular on the part of large institutions (Hüser, Hałaj, Kok, Perales, & van der Kraaij, ; Pais & Stork, ; Zhao, ). Large banks benefit from an implicit public guarantee, as they are supposed to be more likely bailed out than smaller institutions (i.e., they are ‘too‐big‐to‐fail’). This ultimately represents an important market distortion as it allows large banks to raise funding at cheaper rates (Ueda & Weder di Mauro, ).

As recognized even by some supervisors, excessive risk‐taking behavior by banks was, among other reasons, the result of the lack of an effective resolution mechanism. Therefore, motivated by the need to reduce the costs of bank resolutions, especially those borne by taxpayers, and in order to improve market discipline, the Parliament and the Council of the European Union (EU) approved the Bank Recovery and Resolution Directive (BRRD) in 2014. Effective since January 2016, the new regulatory framework for recovery and resolution of banks gives supervisors a set of instruments to intervene at an early stage to prevent situations of bank distress, thus, to ensure business continuity and to reduce the impact on the functioning of the financial system. Nevertheless, the Directive requires that, in the case of irreversible disruption of a bank, in order to restore its viability, equity holders should bear losses first and subsequently unsecured creditors in a predefined hierarchy, while leaving its secured liabilities intact. This could potentially lead unsecured debtholders to see their investment written off or converted into equity (for more details, see, among others, Chennells & Wingfield, ).

The introduction of the BRRD Directive not only can affect banks’ risk‐taking propensity and stability, but it can also have an impact on the bank funding costs because the bail‐in rules transfer risk from taxpayers to unsecured bondholders. Because of this increased risk, holders of bail‐inable liabilities may be expected to ask, ceteris paribus, for higher returns compared to holders of liabilities that are excluded from the bail‐in mechanism. Market discipline (Bliss & Flannery, ; Flannery & Sorescu, ) would predict that the cost of funding for such liabilities would reflect more accurately their actual risks. However, whether investors will ask for a higher risk premium on bank bonds at origination is ultimately an empirical question, which depends on whether they consider the implementation of the BRRD a plausible threat to their savings.

We believe that Italy is an interesting laboratory for testing the effect of the new bail‐in rules on bank funding costs for several reasons. First, Italian banks are quite dependent on bonds as a form of funding compared to banks in other European countries (Coletta & Santioni, ). In addition, the portion of bank bonds in Italian retail investors’ portfolios is rather greater than the average of developed countries (Coletta & Santioni, ; Grasso, Linciano, Pierantoni, & Siciliano, ).

Second, Italian banks place most of their bonds (around 80%) directly with their customers over the counter (OTC) (Coletta & Santioni, ; Gentile & Siciliano, ), thus avoiding the costs associated with the listing of these securities and, more importantly, this gives rise to an obvious conflict of interest. As a consequence, unsophisticated retail investors are the main holders of the banks’ debt securities (Grasso et al., ). Italian banks have benefited from their placing power, which allowed them to raise funding via bond issuances quite cheaply. In fact, Del Giudice () finds that bank bonds were issued at a negative spread (compared to risk‐free securities) prior to the entry into force of the Market in Financial Instruments Directive (MiFID) I regulation. Interestingly, the same author observes that bank bond spreads turn positive as the MiFID I increases the competition among banks and trading venues.

Third, the National Resolution Authority (i.e., the Bank of Italy) applied a quasi bail‐in to four small banks (Banca delle Marche, Banca Popolare dell'Etruria e del Lazio, Cassa di Risparmio della Provincia di Chieti, and Cassa di Risparmio di Ferrara) in November 2015, a few weeks before the official implementation of the bail‐in resolution tool. Notably, although those four regionally chartered banks accounted for less than 2% of the Italian banking market, the news of their quasi bail‐in became the hot topic in the news for a while, which could have enhanced investors’ awareness about the negative consequences of bail‐ins on their savings and investments. In addition, a vast information campaign was properly carried out by the banks in Italy. Indeed, the Italian stock market regulator (CONSOB) late in November 2015 required all the intermediaries to appropriately inform investors about the consequences of the implementation of the BRRD. A survey conducted by the Italian Bankers’ Association (Associazione Bancaria Italiana, ABI) in January 2016 also reveals that several initiatives were adopted to massively inform customers about the switch to the new bail‐in regime via, for instance, a specific leaflet enclosed with the monthly/quarterly bank statements, as well as through fliers handed out at bank branches.

Furthermore, although Italian investors are often blamed for lacking adequate financial literacy (see, among others, Bartiloro, ), a study by Accornero and Moscatelli () reveals that at least recently the information regarding the banks’ fundamentals, such as the Tier 1 capital ratio, influences Italian households’ decisions. Similarly, Boccuzzi and De Lisa () document that market discipline was properly working in Italy around the time the BRRD became effective. Overall, this leads us to reasonably assume that Italian investors improved their awareness about the potential negative effects arising from funding unhealthy banks.

Interestingly, the BRRD introduction might hit the banks with a different intensity depending on their intrinsic characteristics. Indeed, for those banks that in the pre‐BRRD era would have benefited the most from an implicit guarantee, we should observe a greater impact of the new bail‐in rules. Notably, bank‐specific characteristics should influence their bond funding costs with different intensity in the pre‐ and post‐bail‐in phases. To the extent that the bail‐in tool is valued as a credible mechanism by the market, riskier institutions will be the ones who will experience a higher cost of funding after the introduction of the new rules, as well as large banks that should no longer benefit from any implicit public guarantee.

At present, the existing literature mainly focuses on the effect of the new regulatory framework on bank‐specific risk and financial stability. For example, using an event‐study methodology, Schäfer, Schnabel, and Weder di Mauro (2016) analyze the reactions of credit default swap (CDS) spreads and share prices related to European banks after the announcement of some operations in which investors suffered a total or partial bail‐in. The authors find evidence of a significant increase in CDS spreads and a reduction of share prices. More pronounced reactions take place in those countries where the weaknesses of public finances make it more difficult for them to implement the bailout of a large bank. Moreover, the authors emphasize that it is the actual occurrence of a bail‐in, rather than the simple introduction of a new legislation, that produces a concrete reaction. In a similar fashion, Mikosek () investigates the CDS spreads of 20 banks from six European countries, and compares them to the CDS spreads of the corresponding domestic governments. Starting from 2015, the ratio of the average bank CDS spreads over sovereign CDS increases substantially, showing a sharp misalignment between sovereign and bank risk perceptions. This phenomenon demonstrates that the players of this specific market (CDS market) start at one point to discount the fact that governments will not rescue banks any longer. As regards the secondary bond market, a recent study from Giuliana () using a difference‐in‐difference approach finds that bail‐in events amplified the difference in daily yield between bail‐inable (non‐secured) and non‐bail‐inable (secured) bonds. These findings support the notion that the authorities’ efforts to introduce the bail‐in regime increased the bail‐in expectations in the secondary market. Moreover, Giuliana () provides evidence that the bail‐in events reinforced the relationship between a bank's default probability and the price of its securities.

Similar to Giuliana (), we investigate the effectiveness of the new banking regulation by comparing the pricing reaction of unsecured and secured bonds. Indeed, as pointed out by Chan‐Lau and Oura (), the bail‐in increases the cost difference between bail‐inable and non‐bail‐inable bonds.

However, a distinct feature of our paper is that we focus on the primary market of Italian bonds. Notably, we contribute to the literature by measuring the impact of the BRRD...

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