The 2007-2008 financial crisis forced governments to choose between the unattractive alternatives of either bailing out a systemically important bank (SIB) or allowing it to fail disruptively. Bail-in has been put forward as an alternative that potentially addresses the too-big-to-fail and contagion risk problems simultaneously. Though its efficacy has been demonstrated for smaller idiosyncratic SIB failures, its ability to maintain stability in cases of large SIB failures and system-wide crises remains untested. In our longer paper of the same title, (CEPR DP 16509), our main contribution is to assess the financial-stability implications of the bail-in design, explicitly accounting for the multi-layered networked nature of the financial system.
To give a preview of the key take-away message of this blog, our findings indicate that the too-big-to-fail problem remains essentially unresolved at present. Our results suggest that bail-ins under their current design are not a credible alternative to a bail-outs in severe financial crises, such as that experienced in the Great Financial Crisis (GFC), or in cases of idiosyncratic failures of the largest SIBs. On the positive side, our results also suggest that a possible shift towards financial stability remains in the hands of policymakers – even in systemic crises – if bail-in parameters are changed from their “poor” to “good” values. But we fear that political economy incentives make this unlikely. Our findings add to the literature on the too-big-to-fail problem, which includes the work by Berndt et al. (2020) who provide evidence of a decline of too-big-to-fail in the wake of the post-GFC regulatory reforms.
Farmer, J.D., Goodhart, C. & Kleinnijenhuis, A.M. (2021). 'Is the Too-Big-To-Fail Problem Resolved?'. Blog entry. https://www.inet.ox.ac.uk/publications/is-the-too-big-to-fail-problem-resolved/