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Bailouts, Bail-ins and Resolution

Paper Session

Saturday, Jan. 5, 2019 12:30 PM - 2:15 PM

Hilton Atlanta, 305
Hosted By: International Banking, Economics, and Finance Association
  • Chair: John C. Driscoll, Federal Reserve Board

Bank Bailouts, Bail-ins, or No Regulatory Intervention? A Dynamic Model and Empirical Tests of Optimal Regulation

Allen N. Berger
,
University of South Carolina
Charles P. Himmelberg
,
Goldman Sachs & Co.
Raluca A. Roman
,
Federal Reserve Bank of Kansas City
Sergey Tsyplakov
,
University of South Carolina

Abstract

We develop and test a dynamic model of optimal regulatory design of three regimes to deal with distress of large banking organizations. These regimes are 1) bailout, as under TARP; 2) bail-in, as under Orderly Liquidation Authority; and 3) no regulatory intervention, as under Financial CHOICE Act. We find that optimally-designed bail-ins are socially optimal and are the only ones that provide incentives for banks to rebuild capital preemptively during financial distress. Empirical tests of changes in capital ratios and speeds of adjustment in response to shifting from the pre-crisis bailout regime to the post-crisis bail-in regime corroborate model predictions.

Financial Innovation for Rent Extraction

Anton Korinek
,
University of Virginia

Abstract

We show that financial innovation greatly increases the scope for rent extraction from public safety nets, and this may generate a large redistribution of wealth from the public purse to the financial sector and a stark misallocation of real resources. We develop our results in a model in which bailouts arise endogenously: when financial sector capital is low, it is cheaper for the rest of the economy to provide a bailout than to suffer from a large credit crunch. It is well known that bailouts distort incentives to invest in risky securities. We show that bailouts also provide incentives to create new securities that crystallize risk-taking on states of nature in which bailouts will be obtained. This allows for more efficient rent extraction on a significantly larger scale. The incentives for rent extraction are mediated through market prices and do not require that the agents who engage in risk-taking are aware that they are extracting rents from public safety nets, as long as their creditors are. In aggregate, the described behavior leads to large financial sector profits during good times, higher consumption volatility, greater economy-wide risk premia and stark misallocations in real investment.

May the force be with you: Exit barriers, governance shocks, and profitability sclerosis in banking

Felix Noth
,
Halle Institute for Economic Research (IWH)
Michael Koetter
,
Halle Institute for Economic Research (IWH)
Benedikt Fritz
,
Deutsche Bundesbank
Carola Mueller
,
Halle Institute for Economic Research (IWH)

Abstract

We test whether limited market discipline imposes exit barriers and thereby poor profitability in banking. We exploit an exogenous shock to the governance of government-owned banks: the unification of counties. County mergers lead to enforced government-owned bank mergers. We compare forced to voluntary bank exits and show that the former cause better bank profitability and efficiency at the expense of riskier financial profiles. Regarding real effects, firms exposed to forced bank mergers borrow more at lower cost, increase investment, and exhibit higher employment. Thus, reduced exit frictions in banking seem to unleash the economic potential of both banks and firms.

Contagious Bank Runs and Dealer of Last Resort

Kebin Ma
,
University of Warwick
Zhao Li
,
University of International Business and Economics

Abstract

In a global-games framework, we show how a dealer-of-last-resort policy can promote financial stability while traditional lender-of-last-resort policies are informationally constrained: Central banks and private investors can be uncertain whether banks selling assets to fend off runs are insolvent or illiquid. Such uncertainty leads to asset price collapses and runs and restricts central banks' role as a lender of last resort. In the presence of aggregate uncertainty, contagion and price volatility emerge as a multiple-equilibria phenomenon despite the global-games refinement. A dealer-of-last-resort policy that requires no information on individual banks' solvency can contain contagion and stabilize prices at zero-expected costs.
Discussant(s)
Claudio Daminato
,
ETH Zurich
Chang Ma
,
Fudan University
Raluca A. Roman
,
Federal Reserve Bank of Kansas City
Margarita Rubio
,
University of Nottingham
JEL Classifications
  • G1 - General Financial Markets