A New Era for Financial Networks: Mandatory Bail-ins

Abstract

This paper revisits financial networks in a model of counterparty exposures, mandatory bail-ins and complementary bailouts. Under mandatory bail-ins, the network’s role is reshaped and beyond its previous contagion-related role, because counterparty obligations, in the first place, are used for bail-ins against idiosyncratic failures. Di- versification faces a novel tradeoff: As diversification increases, resolution costs are shared by many creditors, and a bailed in creditor’s capital becomes less binding and the aggregate amount of bail-ins increases. However, against large shocks, bail-ins become inadequate and complementary bailouts are needed, then the welfare losses from potential failures determine the government’s decision: for small failure costs, bailouts become costly and higher diversification leads to more unavoided failures. Nevertheless, dense networks have major advantages for non-contagion-related reasons that didn’t exist before and maximize welfare except in extreme cases of system-wide contagion risk.

Keywords: bailouts, bail-ins, bank resolution, contagion, diversification, financial networks, financial regulations, financial stability

JEL Classification: G28, G33