Let the Worst One Fail: A Credible Solution to the Too-Big-To-Fail Conundrum - Thomas Philippon
Speaker : Thomas Philippon (NYU)
We study time-consistent bank resolution mechanisms. When interventions are ex post efficient, a government cannot commit not to inject capital into the banking system. Contrary to common wisdom, however, we show that the government may still be able to implement the first best allocation because it can use the distribution of bailouts across multiple banks to provide ex ante incentives. We show that the efficient mechanism has the feature of a tournament. If each bank’s net transfer from the government can only depend on its own performance, no credible mechanism can prevent maximal risk-taking by all banks. In stark contrast, using relative performance evaluation during the crisis can implement the first-best risk level while remaining credible. In particular, we analyze properties of credible tournament mechanisms that provide support to the best performing banks and resolve the worst performing ones. We extend our framework to allow for contagion and imperfect competition among banks. Our mechanism continues to perform well if banks are partially substitutable and if banks are heterogeneous in their size, interconnections, and thus systemic risk, as long as bailout funds can be targeted to particular banks.