Working Paper: CEPR ID: DP16509
Authors: Alissa Kleinnijenhuis; Charles A. Goodhart; Doyne Farmer
Abstract: The 2007-2008 financial crisis forced governments to choose between the unattractive alternatives of either bailing out a systemically important bank (SIB) or allowing it to fail in a disorderly manner. Bail-in has been put forward as an alternative that potentially addresses the too-big-to-fail problem and contagion risk simultaneously. Though its efficacy has been demonstrated for smaller idiosyncratic SIB failures, its ability to maintain stability in cases of large SIB failures and system-wide crises remains untested. This paper's novelty is to assess the financial-stability implications of bail-in design, explicitly accounting for the multi-layered networked nature of the financial system. We present a model of the European financial system that captures five prevailing contagion channels. We demonstrate that it is essential to understand the interaction of multiple contagion mechanisms and that financial institutions other than banks play an important role. Our results indicate that stability hinges on thebank-specific and structural bail-in design. On the one hand, a well-designed bail-in buttresses financial resilience, but on the other hand, an ill-designed bail-in tends to exacerbate financial distress, especially in system-wide crises and when there are large SIB failures. Our analysis suggests that the current bail-in design may be in the region of instability. While policy makers can fix this, the political economy incentives make this unlikely.
Keywords: Too big to fail; Resolution; Bail-in; Financial crisis; Contagion; Financial networks; Default; Systemically important banks; Bail-in debt pricing; Political economy
JEL Codes: No JEL codes provided
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| well-designed bail-in (G28) | financial resilience (G51) |
| strong recapitalization and high loss absorption requirements (G28) | systemic risks (F65) |
| ill-designed bail-in (G28) | financial distress (G33) |
| ill-designed bail-in (G28) | contagious asset losses (F65) |
| well-designed bail-in (G28) | contagious asset losses (F65) |
| bail-in design (G28) | systemic footprint (F60) |
| contagion mechanisms (C92) | losses (G33) |