Can Contracts Discipline Bankers? Bail-inable Securities and Financial Contracting

The new Recovery and Resolution framework for banks was welcomed as a game changer in addressing financial stability concerns. In particular, the mechanism of internal recapitalisation through which junior and senior creditors are wiped-out and converted into ordinary shares to absorb losses (bail-in) was expected to significantly enhance the level of market discipline. Nonetheless, many studies cast doubts on the efficiency and feasibility of resolution. Similarly, new empirical evidence on market discipline are inconclusive. Moreover, both legal and economic literature so far only focused on price adjustment, neglecting any other possible channel that creditors make use of to discipline bankers, such as contracts.

In my paper, I bring to the spotlight “financial contracting” as a channel to discipline banks’ risk-taking given the incumbent financial regulation. Keeping incumbent regulation as a benchmark to assess the availability and efficiency of contractual clause is crucial in my setting. In fact, the new framework could not resolve the inherent tension between market discipline and financial stability. Indeed, for safeguarding the latter, both capital and resolution framework require financial instruments to comply with certain qualitative requirements in order to be counted as regulatory capital or bail-in eligible securities. Hence, the underlying contribution of the article is to shed additional light on the relationship between financial regulation and bank governance.