Systemic Risk in Financial Networks Revisited: Debt Dilution as a Backdoor Bail-in

Abstract

We develop a model of interbank networks with random liquidity shocks. Networks of dilutable debt---e.g., long-term, unsecured---facilitate efficient liquidity transfers: Shocked banks pledge interbank claims as collateral for new senior debt, diluting existing debt. Unlike with non-dilutable debt, indebtedness and connectedness are sources of stability, not fragility. Dilution is thus a ``backdoor bail-in'' that reallocates losses absent a resolution authority, trigger security, or ex post renegotiation. We uncover a class of networks, ``exponential networks,'' that implement optimal contingent transfers via plain debt. Yet exponential networks are not pairwise stable, whereas some core--periphery networks are, rationalizing observed interbank structures and their under-insurance against crises.