Effects of the EU Resolution Framework on Moral Hazard and Market Discipline
Due to the negative consequences of extensive bank bailouts during the global financial crisis, EU member states adopted the Bank Recovery and Resolution Directive (BRRD) to end the too big to fail dilemma. Additionally, the euro area countries implemented the Single Resolution Mechanism (SRM) as part of the banking union, centralizing decision making and resolution financing. This research assesses both regulations’ effectiveness in counteracting the adverse effects of implicit guarantees by ending morally hazardous behavior and strengthening market discipline.
The author uses rating information to identify affected banks that would have profited from bailouts before the regulations came into effect. Using difference-in-differences models, the author shows that, first, treated banks reduce their risk more drastically in relation to unaffected banks, suggesting the SRM to mitigate moral hazard effectively. Second, other bank-level characteristics like additional capital buffers and high charter values seem to amplify prudent bank behavior. Third, the author provides evidence that the SRM helps restore market discipline, as affected banks are exposed to a relative rise in funding expenses and react accordingly by avoiding risk-sensitive funding. Interestingly, the BRRD does not evoke the aforementioned effects on moral hazard and market discipline.
The results are supported by CDS and equity investors’ short-term responses to the new regulation. Partly, CDS investors display even stronger reactions to the BRRD than to the SRM. Moreover, additional results confirm implicit guarantees to increase risk-taking during the time preceding the policy change, particularly for SRM banks. Furthermore, the investigation of the long-term relation between government support and CDS spreads reveals a structural break in CDS pricing. After adopting the regulation, banks do not benefit from implicit guarantees any longer.
Altogether, the negative consequences of implicit guarantees were significantly higher in the euro area. The SRM seems to be the appropriate remedy for the too big to fail dilemma, increasing market discipline and reducing moral hazard. On its own, the BBRD does not appear to suppress the negative consequences of implicit guarantees, possibly because of lower incentives for moral hazard in the non-eurozone in general.