Bailouts, Bail-ins and Banking Crises

We study the interaction between a government’s bailout policy during a banking crisis and individual banks’ willingness to impose losses on (or “bail in”) their investors. We consider an environment in which banks and investors are free to write complete, state-contingent contracts. Our primary focus is on the timing of this contract’s response to an incipient crisis. In the constrained efficient allocation, banks facing losses immediately cut payments to withdrawing investors. In a competitive equilibrium, however, these banks often delay cutting payments in order to benefit more from the eventual bailout. In some cases, the costs associated with this delay are large enough that investors will choose to run on their bank, creating further distortions and deepening the crisis. Our approach has novel implications for the form a banking crisis must take. A bank run cannot be driven purely by sunspots in our model, for example, it can only occur at banks that have suffered some real losses. In addition, a run can only occur when these losses are systemic, that is, experienced by a large number of banks at once. This run can nevertheless be self-fulfilling in the sense that investors run when their bank suffers losses if and only if they expect other investors to do the same.