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Fluctuating bail-in expectations and effects on market discipline, risk-taking and cost of capital

Raffaele Giuliana

No 133, ESRB Working Paper Series from European Systemic Risk Board

Abstract: Through the compulsory participation of junior investors in bearing losses of their failing bank, the bail-in attempts to limit bail-outs’ side-effects in terms of market discipline, too-big-to-fail, bank-sovereign nexus and risk-taking. This paper assesses the consequences of bail-in expectations along these dimensions ensuring – through a bond pricing study – that bail-in expectations are not confounded by other factors. Using hand-collected details of EU bail-in events, I study both positive and negative exogenous shocks to bail-in expectations, offering three sets of findings. First, bail-in events can reinforce (or weaken) bail-in expectations, as shown by Khwaja-Mian tests (validated by placebo analyses). Second, bail-in expectations promote market discipline, and mitigate too-big-to-fail and bank-sovereign nexus. Third, bail-in effects on bank resilience appear mixed. While it incentivises banks to reduce risk-taking (e.g., increasing risk-weighted equity by a third of Basel III requirement), it also remarkably exacerbates total funding costs through an increase in equity cost (partially off-set by a debt cost reduction). JEL Classification: G21, G28, H81, C23

Keywords: Bail-in; Cost of Capital; Expectations; Financial Stability; Fixed-income Claims; Market Discipline; Rating; Risk-taking (search for similar items in EconPapers)
Date: 2022-03
New Economics Papers: this item is included in nep-ban, nep-cba and nep-eec
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