Bail-ins and Bail-outs: Incentives, Connectivity, and Systemic Stability
NBER Working Paper No. 23747
We develop a framework for analyzing how banks can be incentivized to make contributions to a voluntary bail-in and ascertaining the kinds of interbank linkages that are most conducive to a bail-in. A bail-in is possible only when the regulator's threat to not bail out insolvent banks is credible. Incentives to join a rescue consortium are stronger in networks where banks have a high exposure to default contagion, and weaker if banks realize that a large fraction of the benefits resulting from their contributions accrue to others. Our results reverse existing presumptions about the relative merits of different network topologies for moderately large shock sizes: while diversification effects reduce welfare losses in models without intervention, they inhibit the formation of bail-ins by introducing incentives for free-riding. We provide a nuanced understanding of why certain network structures are preferable, identifying the impact of the network structure on the credibility of bail-in proposals.
Document Object Identifier (DOI): 10.3386/w23747
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