Does BRRD Mitigate the Bank-Sovereign Risk Nexus?

We investigate the effectiveness of the Bank Recovery and Resolution Directive (BRRD) in mitigating the bank-sovereign nexus for 39 banks in 8 Euro Area countries, using CDS spreads to capture bank and sovereign credit risk between 2008-2020. If the BRRD bail-in framework is credible, exogenous bank risk shocks should not be transmitted to sovereign risk. In order to investigate this causality, we adopt an IV approach in which we use bank earnings announcements to identify exogenous shocks to bank credit risk. Our results show that during the negotiation and after the implementation of the BRRD, the bank-sovereign nexus diminished for all countries. The reduction is largest for those countries where the interconnectedness was higher prior to BRRD. However, the dynamic evolution of the transmission channel over time indicates that even with the BRRD in place, there is a period during which the bank-sovereign nexus increases in Italy, coinciding with uncertainty about government involvement in the resolution of failing banks