Assessing the systemic risk impact of bank bail-ins

Abstract

Financial regulation has introduced bail-ins (i.e. enforced debt-to-equity swaps) as a tool for orderly bank resolution, and hence it is the authorities’ task to decide when to apply this tool in a resolution. We present a quantitative framework to support this decision by computing the systemic impact of a bail-in. Our model takes into account systemic feedback effects using state-of-the-art multilayer contagion models, which we extend to include liquidation losses. Using real-world data for the Austrian banking system, we perform an empirical assessment of the systemic risk impact of idiosyncratic and systemic shocks. Our results show that bail-ins have the potential to reduce systemic risk compared to insolvencies for the Austrian banking system. They also incur lower social cost than bail-outs, but only for moderate, idiosyncratic crises. Our findings quantitatively corroborate earlier discussions that bail-ins may be an inadequate tool to deal with systemic crises. This suggests that the bail-in mechanism alone may not be sufficient to rule out future bail-outs.