Optimal Bail-out and Bail-in policy mix: Lessons from the Banco Espírito Santo (BES) failure

This paper evaluates the optimal bail-out and bail-in mix in the case of bankruptcy of Banco Espírito Santo (BES), SA, the second largest Portuguese private bank. The solution after the crisis of the BES, was to partition the bank into a good bank (Novo Banco (New Bank)) and keep the toxic assets and problematic ones in a bad bank, the old BES bank, which would also receive those assets and bonds which were correlated with the ESFG (Espírito Santo Financial Group).
We show, in general, that the optimal policy mix parameter for the regulator’s bail-out and bail-in is contingent on the correlations between the shocks of residuals to the deposits and the shocks to the assets (equity and bonds).
We develop three cases: case A, regulation under perfect information and no shocks, a kind of benchmark; case B; with subcases B1 and B2, which reflect respectively perfect positive correlation between the deposit and assets shocks, and perfect negative correlation; and finally case C, which reflect a general correlation between the deposits and assets, between -1 and 1.
The conclusions, based upon simulations, tend to show that the optimal regulator problem in A was to intervene with optimal bail-out policy mix correspondence between deposit rates (r ) and assets (ra); while at B1 and B2 the optimal mix bail-out case is around 50% with deviation being derived from the correlation between deposits and assets’ residuals.
The main lesson that can be derived from the BES implosion, is that market value of the Novo Banco (New Bank) can be effectively assured if the market decouples for real the Novo Banco from BES, because if the correlation is a perfect fit (+1), new problems might arise in the near future.