Bail-Ins, Optimal Regulation, and Crisis Resolution

Abstract

We provide a contracting framework to understand bank bail-in regimes. In the presence of a monitoring problem, the optimal bank capital structure combines standard debt, which induces liquidation and provides strong incentives, and bail-in debt, which restores solvency but provides weaker incentives. Socially optimal policy increases use of bail-in debt when fire sales make liquidation socially costly. The social optimum can also be implemented using an ex post resolution authority. Although bail-ins replace bailouts of existing debt, they can destabilize bank refinancing during market stress, giving a role for temporary guarantees of new long-term debt in the crisis resolution toolkit.