Liquidation, Bailout, and Bail-In: Insolvency Resolution Mechanisms and Bank Lending

Abstract

We present a dynamic, continuous-time model in which risk averse inside equityholders set a bank’s lending, payout, and financing policies, and the exposure of bank assets to crashes. We examine whether bailouts encourage excessive lending and risk taking compared to liquidation or bail-ins with debt-to-equity conversion or debt write-downs. The effects of the prevailing insolvency resolution mechanism (IRM) on the probability of insolvency, loss in default, and the bank’s value suggest no single IRM is a panacea. We show how a bailout fund financed through a tax on bank dividends resolves bailouts without public money and without distorting insiders’ incentives.