Limiting too-big-to-fail: market reactions to policy announcements and actions

Abstract

Banks considered too-big-to-fail (TBTF) tend to benefit from funding cost advantages as their debt is considered implicitly guaranteed by public authorities, even if the latter have undertaken substantial effort to limit TBTF. This paper focuses on the changes in related market perceptions in response to bank regulatory and resolution reform announcements as well as actual failure resolution actions. It analyses how premia on risky bank debt have reacted to such events, using data for senior and subordinated debt CDS quotes for 45 European banks from January 2007 to May 2020. The empirical results are consistent with progress being made in reducing the value of implicit bank debt guarantees, especially on subordinated bank liabilities. Some earlier bank failure resolution actions appeared to significantly raise risk premia, although more recent failure resolution cases either had no effect on risk premia or moved them in the opposite direction. Several of these events consisted of no-action, that is, in particular, they did not entail any bail-in. As opposed to resolution actions, the reactions of risk premia to policy and regulatory announcements are more difficult to explain and no clear pattern seems to be emerging, confirming the view that action speaks louder than words.