Bank bailouts, bail-ins, or no regulatory intervention? A dynamic model and empirical tests of optimal regulation and implications for future crises

Abstract

We model dynamic bank capital structure under three optimally-designed regulatory regimes for dealing with potential default—bailout, in which the government provides capital; bail-in, which the private-sector provides needed funds; and no regulatory intervention, allowing the institutions to fail. Only under the optimally-designed bail-in regime do banks recapitalize during times of distress. Their pre-commitment to recapitalize reduces debt costs and increases debt capacity. No regulatory intervention is suboptimal for all agents. Optimal bailouts and bail-ins both generate no asset substitution-moral hazard behavior under optimal policies in which regulators intervene at early stages of distress. Empirical tests of changes in capital behavior from the pre-Global Financial Crisis bailout period to the post-crisis bail-in period corroborate the model's predictions.