Law & Banking/Finance Web Seminar Series: Alissa M. Kleinnijenhuis (University of Oxford and MIT)
Jointly organized by Financial Regulation Lab (LabEx ReFi), the New York University (NYU), the Leibniz Institute for Financial Research SAFE (SAFE) and the Center for Advanced Studies on the Foundations of Law and Finance (LawFin). The Webinar Series takes place weekly from June 2 until August 2, 2020, every Tuesday at 3 p.m.
Speaker: Alissa M. Kleinnijenhuis (University of Oxford and MIT)
Title: Systemic Implications of the Bail-In Design
Abstract: The 2007-2008 financial crisis forced governments to choose between the unattractive alternatives of either bailing out a systemically important bank (SIB) or having to disruptively fail it. Bail-in has been put forward as the primary tool to resolve a failing bank, adressing the too-big-to-fail problem and contagion risk simultaneously. Though its efficacy has been evinced for smaller idiosyncratic SIB failures, its aptness in maintaining stability in cases of large SIB failures and system-wide crises remains to be practically tested. This paper’s novelty is to assess the financial-stability implications of the bail-in design, explicitly accounting for the multi-layered networked nature of the financial system. Our European financial system model captures the prevailing amplification mechanisms: exposure loss contagion, overlapping portfolio contagion, funding contagion, bail-inable debt revaluations, and bail-inable debt runs based on expected losses, uncertainty, or similarity. Our results reveal that stability hinges on the bank-specific and structural bail-in design. We show that a well-designed bail-in buttresses financial resilience and consists of an early bail-in, strong recapitalisation, fair distribution of debt-to-equity conversion rates, high loss absorption requirements, fixed exclusions from bail-in of debt with a time to maturity less than one year, and certainty about the bail-in design. On the other hand, an ill-designed bail-in tends to exacerbate financial distress – especially in system-wide crises and with large SIB failures. We also demonstrate that the systemic footprint of the bail-in design is not properly understood without the inclusion of multiple contagion mechanisms, which may amplify initial bail-in losses, and non-banks, who hold much of the bail-inable debt. Our evidence fortunately suggests that the pivot for stability is in the hands of policymakers. It also suggests, however, that the current bail-in design might be in the regime of instability.