Government Guarantee, Investment, and the Welfare Effects

Creditor bail-in is a new resolution regime under which failed banks are resolved at the costs of creditors rather than taxpayers, which essentially implies that banks cannot rely on government guarantees anymore. G20 and other developed countries agree on accepting this new regime since bail-in could arguably resolve several fundamental problems of bailouts such as banks’ moral hazard, fiscal instability, and economic injustice. However, there is an opposing view on bail-in: as government guarantees are abolished, investment would be discouraged and hence social welfare decreases. This paper focuses on this opposing view and clarifies when this view is valid and when it is not. In under-developed financial systems, financial constraints are strong and the related problem of insufficient investment could be exacerbated as government guarantees are abolished. In advanced financial systems, by contrast, financial constraints are weaker and the related problem of excessive investment could be mitigated after the abolition.