Believing in bail-in? Market discipline and the pricing of bail-in bonds

Focus

Shareholders and unsecured creditors should bear the losses if a firm fails. During past crises, this simple principle did not hold for banks considered "too big to fail". Bail-in regulation seeks to address this problem by earmarking some debt instruments as "bail-inable". If bail-in regulation functions well, the investors in these instruments should expect to bear losses in the course of resolution. Accordingly, they should monitor banks and exert discipline on their risk-taking. This paper studies whether this is indeed the case.

Contribution

We explore the global market for bail-inable bank debt, focussing on the largest market segment: senior unsecured bonds. We identify the bail-in risk premium by carefully matching these bonds with comparable senior bonds that are not subject to bail-in risk. We identify the main drivers of the bail-in risk premium for global systemically important banks (G-SIBs) and other major banks.

Findings

Investors exert market discipline on G-SIBs by demanding a bail-in risk premium. We find that this premium averages 20 basis points (2016-18), with riskier banks having to pay even more. Yet the bail-in premium varies pro-cyclically: when market-wide credit risk declines, the premium falls, and it does so most strongly for the riskier issuers. Banks take advantage of this pattern and time their bail-in bond issuance accordingly. The flipside of compressed premia during good times is that, during periods of market stress, riskier issuers could be exposed to material increases in the cost of bail-in debt. This reinforces the value of a conservatively calibrated bail-in regime alongside stringent supervision to ensure that banks build up their resilience during good times.

Abstract

Bail-in regulation is a centrepiece of the post-crisis overhaul of bank resolution. It requires major banks to maintain a sufficient amount of "bail-in debt" that can absorb losses during resolution. If resolution regimes are credible, investors in bail-in debt should have a strong incentive to monitor banks and price bail-in risk. We study the pricing of senior bail-in bonds to evaluate whether this is the case. We identify the bail-in risk premium by matching these bonds with comparable senior bonds that are issued by the same banking group but are not subject to bail-in risk. The premium is higher for riskier issuers, consistent with the notion that bond investors exert market discipline on banks. Yet the premium varies pro-cyclically: a decline in marketwide credit risk lowers the bail-in risk premium for all banks, with the compression much stronger for riskier issuers. Banks, in turn, time their bail-in bond issuance to take advantage of periods of low premia.

JEL codes: E44, E61, G28

Keywords: too big to fail, banking regulation, TLAC, financial stability