Bail-ins and Bail-outs: Incentives, Connectivity, and Systemic Stability

We develop a framework for analyzing how banks can be incentivized to make contributions to a voluntary bail-in and ascertaining the kinds of inter-bank linkages that are most conducive to a bail-in. Incentives for banks to contribute to a bail-in arise from their exposure to credit and price-mediated contagion.  In equilibrium, a bail-in is possible only if the regulator’s threat to not bail out insolvent banks is credible. Contrary to models without intervention or with government bailouts only, sparse networks are beneficial for two main reasons: they improve the credibility of the regulator’s no-bailout threat for large shocks and they reduce free-riding incentives among bail-in contributors when the threat is credible. (joint work with Benjamin Bernard and Joseph Stiglitz)