Bail-Ins: Cyclical Effects of a Common Response to Financial Crises
20 Pages Posted: 3 Oct 2010 Last revised: 4 Jan 2012
Date Written: October 1, 2010
In the wake of financial crises, public authorities often respond by using law to modify private contracts to transfer value from those who fare better in the crisis to those who fare worse. From the perspective of the crisis victim, this is a bailout. Because this article focuses on the perspective of the other party to the contract (specifically, on the incentives this response creates to that party), this article will refer to such responses as “bail-ins”. Recent examples include staying foreclosures, authorizing bankruptcy courts to modify mortgage terms, or threatening criminal prosecution to induce banks to undo transactions made with their clients.
Bail-ins have greater political appeal than other forms of redistributive government action (e.g., increased government spending and taxation). Bail-ins are expected to reduce future investment, as investors fear similar actions in future crises. But how harmful is that? Market-skeptics question that the market correctly determines the optimal amount of investment, and are thus untroubled by government’s manipulation of it. And to appease those who do trust market allocation of investment, government can offset the investment reduction by subsidizing investment (e.g., making mortgage interest tax-deductable to encourage lending and offset the effects of staying foreclosures or of court-modified mortgage terms).
This essay argues that bail-ins are significantly harmful from both market-trusting and market-skeptic perspectives. Rather than a permanent reduction in future investment, bail-ins reduce investment cyclically – significantly when the bail-in is imposed, but declining gradually as cognitive biases cause managers to underestimate the risk of future contract modifications and agency costs incentivize the managers to increase investment regardless of future bail-in risk.
Cyclical fluctuation in investment deterrence may seem less harmful than permanent deterrence, but the opposite is true. As this essay explains, cyclical fluctuation of investment makes bail-ins harmful from the perspectives of both market-skeptics and market-trusters, and exacerbates the magnitude of future business cycles.
Keywords: bailout, financial crisis, business cycle, retroactive, agency problem, cognitive bias, contract modification
JEL Classification: D23, D72, D92, E32, H23, H32, K12, K22
Suggested Citation: Suggested Citation