DP13734 Liquidation, bailout, and bail-in: Insolvency resolution mechanisms and bank lending.
We present a dynamic, continuous-time model in which risk averse inside equityholders set a bank's lending, payout, and financing policies, and the exposure of bank assets to crashes. We study how the prevailing insolvency resolution mechanism affects these policies, the insolvency rate, loss in default, value at risk (VaR), and the net value created by the bank. VaR depends non-trivially on jump (crash) risk, diffusion risk and the horizon. We examine the commonplace assertion that bailouts encourage excessive lending and risk-taking compared to the liquidation and bail-in regimes, and explore whether bailouts could be financed by banks without taxpayers' money.