Bail-in vs. Bailout: A Persuasion Game

Abstract

We propose a model with incomplete information where a distressed bank asks its creditor, a healthy bank, to reduce its debt. Given the information disclosed by the regulator about the asset quality of the distressed bank and its possible bailout by the government, the healthy bank can accept or not the bail-in operation. The role of the regulator is to select the optimal disclosure rule that reduces its expected loss function. We find that the full disclosure is desirable in some circumstances, especially in extreme periods, but not in others. For instance, when the bail-in cost is large, the optimal loss is reached thanks to a partial disclosure in normal times. In contrast, when the bailout cost is high, no disclosure minimizes the regulator's expected welfare losses in normal times.