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

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. The effect of the prevailing insolvency resolution mechanism (IRM) on the probability of insolvency, loss in default, and the net value created by the bank suggests no single IRM is a panacea. We examine whether bailouts encourage excessive lending and risk-taking compared to bail-in or liquidation. We show how a bailout fund financed through a tax on bank dividends could resolve bailouts without public money and without distorting insiders' incentives