The 2007-2008 financial crisis forced governments to choose between the unattractive alternatives of either bailing out a systemically important bank (SIBs) or having it fail in a disruptive manner. Bail-in has been put forward as the primary tool to resolve a failing bank, which would end the too-big-to-fail problem by letting stakeholders shoulder the losses, while minimising the calamitous systemic impact of a bank failure. Though the aptness of bail-in has been evinced in relatively minor idiosyncratic bank failures, its efficacy in maintaining stability in cases of large bank failures and episodes of system-wide crises remains to be practically tested. This paper investigates the financial stability implications of the bail-in design, in all these cases. We develop a multi-layered network model of the European financial system that captures the prevailing endogenous-amplification mechanisms: exposure loss contagion, overlapping portfolio contagion, funding contagion, bail-inable debt revaluations, and bail-inable debt runs. Our results reveal that financial stability hinges on a set of `primary' and `secondary' bail-in parameters, including the failure threshold, recapitalisation target, debt-to-equity conversion rate, loss absorption requirements, debt exclusions and bail-in-design certainty – and we uncover how. We also demonstrate that the systemic footprint of the bail-in design is not properly understood without the inclusion of multiple contagion mechanisms and non-banks. Our evidence fortunately suggests that the pivot for stability is in the hands of policymakers. It also suggests, however, that the current bail-in design might be in the regime of instability.
