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

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.

Keywords: Liquidation, bailout, bail-in, asset sale, agency

JEL Classification: G33, H81, G34, G32

Suggested Citation: Suggested Citation

Lambrecht, Bart and Tse, Alex S. L., Liquidation, Bailout, and Bail-in: Insolvency Resolution Mechanisms and Bank Lending (May 12, 2021). Forthcoming in the Journal of Financial and Quantitative Analysis, Available at SSRN: https://ssrn.com/abstract=3123170 or http://dx.doi.org/10.2139/ssrn.3123170