Allocating losses: Bail-ins, bailouts and bank regulation

We study the interaction between the government's bailout policy and a bank's willingness to impose losses on (or “bail in”) investors based on its private information. In the absence of regulation, bail-ins in the early stages of a crisis are too small, while bailouts are too large and too frequent. Moreover, the bank may face a run by informed investors, creating further distortions and leading to a larger bailout. We show how a regulator with limited information can raise welfare and, in some cases, improve financial stability. The optimal policy involves partial delegation: the regulator sets bounds on the size of the bank's bail-in, but allows the bank to choose within these bounds.