Working Paper: NBER ID: w23747
Authors: Benjamin Bernard; Agostino Capponi; Joseph E. Stiglitz
Abstract: This paper endogenizes intervention in financial crises as the strategic negotiation between a regulator and creditors of distressed banks. Incentives for banks to contribute to a voluntary bail-in arise from their exposure to financial contagion. In equilibrium, a bail-in is possible only if the regulator’s threat to not bail out insolvent banks is credible. Contrary to models without intervention or with government bailouts only, sparse networks enhance welfare for two main reasons: they improve the credibility of the regulator’s no-bailout threat for large shocks and they reduce free-riding incentives among bail-in contributors when the threat is credible.
Keywords: Bail-ins; Bailouts; Systemic Stability; Financial Networks
JEL Codes: D85; E44; G21; G28; L14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Credible threat of regulator's no-bailout (G28) | Increased likelihood of banks contributing to bail-in (F65) |
| Increased likelihood of banks contributing to bail-in (F65) | Prevention of default cascade (G33) |
| Regulator's no-bailout threat credible (G28) | Banks incentivized to participate in bail-in (G28) |
| Sparse networks (D85) | Enhanced welfare by minimizing freeriding incentives (D69) |
| Dense networks (D85) | Exacerbation of freeriding issues (H40) |
| Total throughput of defaulting banks (G33) | Measurement of credibility of regulator's threat (G18) |
| Interconnectedness of banks (F65) | Propagation of financial contagion during crises (F65) |
| Effective negotiation of bail-ins (G33) | Minimized welfare losses (D69) |
| Decision to rescue banks (G28) | Influenced by fundamental shocks or contagion effects (F65) |