Liquidation, Bailout, and Bail-In: Insolvency Resolution Mechanisms and Bank Lending

Bart M. Lambrecht and Alex S. L. Tse

Journal of Financial and Quantitative Analysis, 2023, vol. 58, issue 1, 175-216

Abstract: We present a dynamic, continuous-time model in which risk averse inside equityholders set a bank’s lending, payout, and financing policies, and the exposure of bank assets to crashes. We examine whether bailouts encourage excessive lending and risk taking compared to liquidation or bail-ins with debt-to-equity conversion or debt write-downs. The effects of the prevailing insolvency resolution mechanism (IRM) on the probability of insolvency, loss in default, and the bank’s value suggest no single IRM is a panacea. We show how a bailout fund financed through a tax on bank dividends resolves bailouts without public money and without distorting insiders’ incentives.

Date: 2023
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