Bail-in and Bailout: Friends or Foes?

This paper analyzes the effects of bail-in and bailout policies on banks’ funding costs, incentives for loan monitoring, and financing capacity. In a model with moral hazard and two investment stages, a full bail-in turns out to be, ex post, the optimal policy to deal with a failing bank. Unlike a bailout, it allows the government to recapitalize the bank without resorting to distortionary taxes. As a consequence, however, investors expect bail-ins rather than bailouts. Ex ante, this raises banks’ cost of debt and depresses bankers’ incentives to monitor. When moral hazard is severe, this time inconsistency leads to a credit market collapse in which productive projects are not financed, unless the government precommits to an alternative resolution policy. The optimal policy is either a combination of bail-in and bailout—in which the government uses a minimal amount of public transfers to lower banks’ cost of debt—or liquidation, depending on the severity of moral hazard and the shadow cost of the partial bailout.