DP14048 Rules versus Discretion in Bank Resolution

Author(s): Ansgar Walther, Lucy White
Publication Date: October 2019
Keyword(s): bail-in, bail-out, bank resolution, bank runs, financial crises
JEL(s): G01, G18, G21
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14048

Recent reforms give regulators broad powers to "bail-in" bank creditors during financial crises. We analyze efficient bail-ins and their implementation. To preserve liquidity, regulators must avoid signalling negative private information to creditors. Therefore, optimal bail-ins in bad times depend only on public information. As a result, the optimal policy cannot be implemented if regulators have wide discretion, due to an informational time-inconsistency problem. Rules mandating tough bail-ins after bad public signals, or contingent convertible (co-co) bonds, improve welfare. We further show that bail-in and bailout policies are complementary: if bailouts are possible, then discretionary bail-ins are more effective.