Bail-inable Securities and Financial Contracting: Can Contracts Discipline Bankers?

Abstract

The post-crisis stream of reforms, especially the new recovery and resolution framework, has been often welcomed for its aim to increase market discipline in the banking sector, allocating the losses to shareholders and creditors of failing banks and not anymore on the general public though state bail-out. Nonetheless, the concrete mechanisms according to which such turnaround shall happen and the corporate governance consequences of financial reforms have been severely understudied.

The paper tackles the trade-off between market discipline and financial stability in the post-crisis EU regulatory environment through the lenses of financial contracting. Building on the debt as a mechanism to contingently allocate control, the paper approaches the regulatory framework as a set of restrictions to contractual freedom, exploring the room for investors to discipline risk-taking of banks through specific contractual arrangements.

Traditional contractual devices are scrutinized against the qualitative requirements for regulatory capital and bail-inable securities and turned out to be largely unavailable because of regulatory constraints, so that the ability of investors to limit risk-taking appetite of managers is limited. Therefore, the attention moves to the peculiar case of contingent convertible instruments (Cocos), discussing some design features that might allow investors to successfully reduce risk-taking incentives both before and after the distress of the bank, enhancing market discipline after all.

Keywords: Incomplete contracts, Corporate governance, Banking regulation, Bail-in, Contingent convertible

JEL Classification: G21; G33; K29