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Systemic implications of the bail-in design: a precis of our main text

Farmer, J. Doyne, Goodhart, C. A. E. and Kleinnijenhuis, Alissa M. (2020) Systemic implications of the bail-in design: a precis of our main text. SUERF Policy Notes (257). SUERF The European Money and Finance Forum, Vienna, AT.

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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 contribution 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 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 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. In all, our findings indicate that the too-big-to-fail problem remains unresolved today.

Item Type: Monograph (Report)
Official URL: https://www.suerf.org/policynotes
Additional Information: © 2021 SUERF - The European Money and Finance Forum
Divisions: Financial Markets Group
Subjects: H Social Sciences > HC Economic History and Conditions
H Social Sciences > HG Finance
H Social Sciences > HB Economic Theory
JEL classification: G - Financial Economics > G1 - General Financial Markets > G10 - General
G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing; Trading volume; Bond Interest Rates
G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing; Futures Pricing
G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
G - Financial Economics > G2 - Financial Institutions and Services > G28 - Government Policy and Regulation
G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure
G - Financial Economics > G3 - Corporate Finance and Governance > G33 - Bankruptcy; Liquidation
P - Economic Systems > P1 - Capitalist Systems > P16 - Political Economy
Date Deposited: 14 Oct 2021 10:45
Last Modified: 14 Oct 2021 23:16
URI: http://eprints.lse.ac.uk/id/eprint/112434

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