The Dark Side of Bank Resolution: Counterparty Risk through Bail-in
53 Pages Posted: 11 Jan 2019
Date Written: January 11, 2019
The introduction of bail-in resolution powers to impose the costs of a large bank’s failure on its creditors (rather than on the taxpayer) is the most enthralling initiative of the post-financial crisis regulatory framework. However, one important conundrum remains in the elaborate bail-in regime: it is unclear who is best qualified to hold bank capital that is subject to bail-in. This paper argues that such regulatory agnosticism as to the ideal counterparty of bail-inable debt is subverting the new bail-in tool altogether, verily inducing banking capital investors to counterproductively choose outcomes that further systemic risk. Using a difference-in-differences methodology, we provide evidence from the introduction of bail-in powers at the Eurozone level, confirming that it has led to a growing interconnectedness of banks. We then discuss the regulatory challenges of addressing the problem of banking capital counterparties and develop Coasian-style principles that may improve the current framework. This article builds upon the literature by providing an analysis of the interaction between banking capital counterparties and bail-in; identifying a significant gap in the regulatory framework; and explaining why Coasian, as opposed to prescriptive, regulatory measures are necessary.
Keywords: bail-in, bank resolution, interconnectedness, systemic risk, Eurozone
JEL Classification: G21,G28,G33
Suggested Citation: Suggested Citation