Regulation and Reputation

Bail-in bonds are gaining a lot of attention among bank regulators. In principle, these bonds raise the hurdle for a government bailout by converting into loss-absorbing capital once the issuing bank runs into trouble. We show that imposing bail-in requirements on all banks can actually increase the need for a bailout. In our model, the probability that a bank runs into trouble depends on the bank's individual state and an aggregate state. Individual states are private information but banks can provide signals to investors by offering bail-in bonds with implicit guarantees against conversion. The bond itself appears as a bail-in bond on the issuer's balance sheet while the guarantee is booked off balance sheet until the bond converts. Naturally, bail-in bonds with implicit guarantees are only traded if investors believe that banks will honor the guarantees. Our model reveals a network effect which (1) lowers the cost of honoring guarantees and (2) generates more implicit guarantees than would be sustainable in a pure reputation equilibrium. An implicit guarantee is only discovered when the issuer is weak so, in a model with aggregate shocks, regulatory promises to punish guarantees are less credible when guarantees are widespread. At the same time, because individual shocks are also present, signaling motives for offering an implicit guarantee are strongest when the regulator is expected to start triggering conversions. Bail-in bonds with implicit guarantees thus proliferate precisely when they undermine the bail-in purpose. Once the bonds start to convert, the guarantees drain liquidity from bank balance sheets and a sizable bailout may be needed to shore up the banking system.