Bank Resolution and Public Backstop in An Asymmetric Banking Union

Abstract

This paper characterizes the optimal banking union with endogenous participation in a two-country economy in which domestic bank failures may be contemporaneous to sovereign crises, giving rise to risk-sharing motives to mutualize bail-out funding. Raising public funds to conduct bail-outs entails a deadweight loss. Bank bail-ins create disruption costs. The optimal resolution trades-off these costs. Truthfully eliciting information from domestic authorities imposes a domestic co-payment to fund bail-outs. When country asymmetry is large, ensuring the ex-ante participation of the fiscally stronger country requires a reduced contribution by this country, which increases the likelihood of bailing out its failing bank.