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Systemic implications of the bail-in design

Farmer, J. Doyne, Goodhart, C. A. E. and Kleinnijenhuis, Alissa M. (2021) Systemic implications of the bail-in design. CEPR discussion papers (DP16509). Centre for Economic Policy Research (CEPR), London, UK.

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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 disruptively. Bail-in has been put forward as an alternative that potentially addresses the too-big-to-fail and contagion risk problems 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 multilayered networked nature of the financial system. We present a model of the European financial system that captures all five of the 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 the bank-specific and structural bail-in design. On one hand, a welldesigned 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.

Item Type: Monograph (Discussion Paper)
Official URL: https://cepr.org/content/discussion-papers
Additional Information: © 2021 The Authors
Divisions: Financial Markets Group
Subjects: H Social Sciences > HG Finance
Date Deposited: 13 Sep 2021 08:27
Last Modified: 13 Sep 2021 11:48
URI: http://eprints.lse.ac.uk/id/eprint/111903

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