Bail-ins and Bail-outs: Incentives, Connectivity, and Systemic Stability
NBER Working Paper No. 23747
This paper develops a framework to analyze the consequences of alternative designs for interbank networks, in which a failure of one bank may lead to others. Earlier work had suggested that, provided shocks were not too large (or too correlated), denser networks were preferred to more sparsely connected networks because they were better able to absorb shocks. With large shocks, especially when systems are non-conservative, the likelihood of costly bankruptcy cascades increases with dense networks. Governments, worried about the cost of bailouts, have proposed bail-ins, where banks contribute. We analyze the conditions under which governments can credibly implement a bail-in strategy, showing that this depends on the network structure as well. With bail-ins, government intervention becomes desirable even for relatively small shocks, but the critical shock size above which sparser networks perform better is decreased; with sparser networks, a bail-in strategy is more credible.
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Document Object Identifier (DOI): 10.3386/w23747