Bank Bailouts, Bail-Ins, or No Regulatory Intervention? A Dynamic Model and Empirical Tests of Optimal Regulation

Abstract

We model dynamic bank capital structure under three optimally-designed regulatory regimes dealing with potential default { bailout, where government provides capital; bail-in, using private-sector funds; and no regulatory intervention, allowing failure. Only under optimally designed bail-in do banks recapitalize during 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 generate no asset substitution-moral hazard behavior because regulators intervene at early stages of distress with sufficient capital remaining. Empirical tests of changes in capital behavior from the pre-crisis bailout period to the post-crisis bail-in period corroborate model predictions.