DP12104 Equity versus Bail-in Debt in Banking: An Agency Perspective

Author(s): Caterina Mendicino, Kalin Nikolov, Javier Suarez
Publication Date: June 2017
Keyword(s): agency problems, bail-in debt, Bank Regulation, loss absorbing capacity, risk shifting
JEL(s): G21, G28, G32
Programme Areas: Financial Economics
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=12104

We examine the optimal size and composition of banks' total loss absorbing capacity (TLAC). Optimal size is driven by the trade-off between providing liquidity services through deposits and minimizing deadweight default costs. Optimal composition (equity vs. bail-in debt) is driven by the relative importance of two incentive problems: risk shifting (mitigated by equity) and private benefit taking (mitigated by debt). Our quantitative results suggest that TLAC size in line with current regulation is appropriate. However, an important fraction of it should consist of bail-in debt because such buffer size makes the costs of risk-shifting relatively less important at the margin.