The Dark Side of Bank Resolution: Counterparty Risk through Bail-in

Abstract

The introduction of bail-in resolution powers to impose the costs of a large bank’s failure on its creditors (rather than on the taxpayer) is the most intriguing initiative of the post-financial crisis regulatory framework. However, a fundamental conundrum remains in the legal regime: it is unclear who should hold bank capital that is subject to bail-in. This paper argues that such regulatory agnosticism as to the ideal counterparties of bail-in-able debt facilitates the subversion of the new bail-in tool. This includes inducing banking capital investors to counterproductively choose outcomes that further systemic risk. Using a difference-in-differences methodology, we provide evidence from the introduction of bail-in powers at the Eurozone level, showing that the introduction of bail-in powers went hand in hand with a growing interconnectedness of European banks. This confirms that counterparties matter fundamentally to bail-in, in a way that might be counterproductive for the objectives of bail-in, and that this counterproductivity results within the current regulatory framework’s prescriptive paradigm. We then discuss the challenges of regulating individual entities, within the financial system ‘commons’, to optimise banking capital counterparties. In particular, we develop Coasian, as opposed to prescriptive, principles that are likely to improve the current framework by facilitate learning about and adjusting to systemic risk. This article builds upon the literature by providing an analysis of the interaction between banking capital counterparties and bail-in; identifying a significant gap in the regulatory framework; and explaining why Coasian regulatory measures are necessary.