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    BIS Paper Studies Market Discipline and Pricing of Bail-in Bonds

    December 17, 2019

    BIS published a working paper that examines whether the market for bail-in debt imposes discipline on banks by analyzing the pricing of senior unsecured bank bail-in bonds of global systemically important banks (G-SIBs) and other large banks. Bail-in regulation is a centerpiece 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. The authors study the pricing of senior bail-in bonds to evaluate whether this is the case. The authors identify the bail-in risk premium by matching bonds with comparable senior bonds that are issued by the same banking group but are not subject to bail-in risk.

    Bail-in regimes are a core component of the post-crisis overhaul of bank resolution. These regimes require banks to issue sufficient amounts of “bail-in” debt to ensure that a failing bank can be resolved in orderly way, without disrupting crucial financial services. The expectation that investors in bail-in debt would exert discipline on banks through their pricing decisions is another key element of these regimes. The authors shed light on the existence and strength of market discipline in senior bail-in bond markets. There are four main findings. First, the authors identify a bail-in risk premium (BIRP), the evidence that investors are pricing bail-in risk. Second, investors in riskier banks are compensated through a larger BIRP. Third, discrimination across banks becomes weak when market-wide credit conditions ease. Fourth, issuers exploit this weakening in investor monitoring by timing their bail-in bond issuance to favorable market conditions.

    The estimates may be interpreted as a lower bound on the effect of issuer and market risk factors on the BIRP for two reasons. First, the study focuses on large banks that frequently tap bond markets and issue in large amounts. This allows for a global comparison across the systemically most important banks and provides for an accurate measure of the BIRP based on tightly matched bonds in liquid markets. Smaller banks, with less regular presence in primary bond markets, could face greater challenges in building up their stock of required bail-in eligible debt. Second, the results stem from the analysis of a comparatively calm period of observation (2016–18). This period was marked by relatively low volatility in bond markets, amid investors’ search for yield in a very low interest rate environment.

    Examining how the bail-in bond market performs under stress remains a topic for future research. An extrapolation of the results to periods of stress suggests that riskier issuers could be exposed to material increases in the cost of bail-in debt. Although banks can time their issuance to some extent, prolonged periods of stress could force some banks to tap the market at exceptionally high cost. From a policy perspective, the observed pro-cyclicality in the BIRP reinforces the value of a conservatively calibrated bail-in regime alongside stringent supervision to ensure that, during good times, banks build up their resilience and keep their risk-taking in check.

     

    Related Link: Working Paper

    Keywords: International, Banking, Securities, Bail-in, G-SIBs, TLAC, Too Big to Fail, BIRP, Bail-in Regime, Bank Resolution, Research, BIS

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