Renegotiation, Commitment, and Bank Resolution, with Maximilian Guennewig (New draft coming soon!)
A bank seeks to finance a risky asset of unknown quality by posting contracts to a market of investors. After financing but before maturity, information about the quality of the asset is publicly revealed. Parties cannot commit not to renegotiate the existing contracts, and the returns of the asset depend in part on costly actions borne by the ultimate equity holders. To this set-up we add a regulator who cares about welfare, and who can intervene by injecting costly public funds (bail-outs), and by coercively altering the private contractual arrangements. We interpret the last policy as a ‘bail-in.’
The distinctive feature of our environment is the lack of commitment by all parties. We derive necessary and sufficient conditions for when demandable-debt contracts arise. In those cases, the bank benefits from fragilities and endogenously generates inefficient liquidation, which prevents the regulator from conducting bail-ins. Consequently, even when bail-ins are available the regulator is incapable to commit not to bail-out.