Bailing in Banks: costs and benefits

We investigate the effectiveness of bail-in mechanisms in mitigating systemic risk and welfare costs to society during resolution processes. To perform this study, we define a network model of mutually exposed banks and use it to simulate the effects of shocks to these banks using granular data of the Brazilian banking system, its interbank exposures and credit register operations. In the simulations, we compare the outcomes of these initial shocks after resolution processes with and without bail-ins. The simulations show that by avoiding the liquidation of banks and the resulting interruption in their credit provision, bail-ins would be effective in preventing the amplification of losses imposed on the real sector. Analyzing the effects that the liquidation of Brazilian Domestic Systemically Important Banks (D-SIBs) would cause to credit provision to economic sectors, we find bailing in these banks would produce a relevant decrease in credit crunches. However, in our sample, only a few banks could benefit from bail-ins due to insufficiency of bail-inable instruments. To tackle this issue, we carry out a study based on counterfactual simulations to assess if and how setting requirements for bail-inable instruments would affect the likelihood of a successful bail-in. We find the number of small and medium banks that could benefit from a bail-in would grow substantially for small increases in these requirements.