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03 July 2018

IMF Blog: How to deal with failed banks


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IMF study looks at the question of what to do when a bank fails. Using public funds to rescue failing banks (bail-outs) could weaken market discipline and lead to excessive risk taking—the moral hazard effect. Letting private investors absorb the losses (bail-ins) could destabilize the financial sector and the economy as a whole—the spillover effect.


IMF advocates a resolution framework that carefully balances the moral hazard and spillover effects and improves the trade-off. Such a framework would make bail-outs the exception rather than the rule.

Not all crises are alike. Some are isolated, with little or no spillover effect. In those cases, bail-outs would merely create moral hazard. Resolving a failing bank should rely on bail-ins: private stakeholders should bear the losses.

Other crises are systemic, and affect all corners of an economy or many countries at the same time.

The destabilizing spillovers associated with bank failures in such a situation would justify the use of public resources: moral hazard still exists but is bearable compared to the alternative of a severe crisis that hurts all, including those without a stake in the troubled bank.

So, the framework should commit to using bail-ins in most cases and allow use of public funds only when the risks to macro-financial stability from bail-ins are exceptionally severe.

The best way to avoid such dilemmas is to reduce spillovers and the need for bail-outs in the first place. This can be achieved through two mutually re-enforcing mechanisms.

The first mechanism is reducing the likelihood of crises and minimizing costs should a crisis occur. This translates into having a more resilient banking system: less leverage and risk taking, and more capital and liquidity. Then the odds that a bank runs into trouble are smaller. And, if there is trouble, banks can absorb the losses without help from the government.

The second mechanism is making the bail-in option viable. The problem is that policymakers may make the promise to bail in a troubled bank but, in a crisis, they will be tempted to bail them out. So people will not believe that bail-ins will happen and continue to expect bail-outs.

Full article

Full study



© International Monetary Fund


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