BRRD credibility and the bank-sovereign nexus

ABSTRACT

We investigate the effectiveness of the Bank Recovery and Resolution Directive (BRRD) in mitigating the bank-sovereign nexus in the Euro Area. Using CDS spreads to measure bank and sovereign credit risk and a DCC-MIDAS model capturing the long-term component of bank-sovereign interconnectedness, we document that the dynamic correlation between banks and sovereigns has decreased in Euro Area countries since the introduction of the BRRD. Panel data analysis reveals that the decline in interconnectedness is not driven by the banks’ capital adequacy, size or holdings of domestic sovereign securities.

KEYWORDS:

• BRRD
• bank-sovereign nexus
• CDS spread
• dynamic correlation
• DCC-MIDAS

JEL CLASSIFICATION:

• C58
• G28
• G32

Acknowledgments

We thank Kris Boudt, Selien De Schryder, Koen Inghelbrecht, Gert Peersman, Mathieu Simoens and seminar participants at the EFMA Annual Meeting, WEAI 96th Annual Conference and Ghent University Banking and Finance seminar for helpful comments and suggestions. The authors acknowledge financial support from the Research Foundation - Flanders (FWO).

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

¹ For a detailed description of the DCC-MIDAS model and estimation procedure, we refer the reader to Colacito, Engle, and Ghysels (2011). To guide the maximum likelihood estimation algorithm, we introduce boundaries on the $a(>0.08)$ and $b(<0.80)$ parameters.

² Similar to Pancotto, Ap Gwilym, and Williams (2019) we use 1 January 2015 as treatment date.

Additional information

Funding

This work was supported by the Research Foundation Flanders [FWO.OPR.2018.0096.01.].