The Bail-in Beyond Unpredictability: Creditors’ Incentives and Market Discipline

Abstract

Market Discipline of creditors on risk-taking behaviours of borrowing banks represents a long-lasting debate. Such a debate gained new attention after the post-crisis stream of reforms concerning resolution policy: creditors should be incentivized to take optimal effort in monitoring their borrowers and, at the same time, their interests have been aligned with the social ones. Many commentators criticized such an expectation especially in the European context, arguing that the lack of credibility and excessive complexity of the resolution mechanism impairs the ability and willingness of creditors to exert disciplining role. This paper aims at taking a step forward in this scientific debate, investigating whether the ability to exert disciplining activity is inherently impaired by the design of the Directive. In other words, this research wants to assess if, assuming an ideal environment, creditors would have optimal incentives to monitor the bank’s behaviours and react accordingly. To do so, the paper reviews the literature on Market Discipline, then carries out a legal analysis of the Bank Recovery and Resolution Directive (BRRD), focusing on those norms shaping the market for bail-inable securities. Eventually, the incentives stemming from those norms are discussed, assuming an ideal environment where bail-in is certain and credible and the market for bail-inable securities works smoothly. The analysis highlight that the incentives of creditors toward market discipline are inherently diluted by the BRRD legal design because of competing policy objectives pursued by the Directive. The direct normative consequence of such a finding is that enhancing information and predictability, though desirable in principle, will never lead to optimal monitoring effort, leaving the floor to alternative rule-based strategies.

Keywords: Law and finance, Bank resolution, Bail-inable creditors, Market discipline, ‘No creditor worse off’ rule

JEL Classification: G01; G21; G33; K29