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Constrained optimal bank resolutions

Minimum TLAC requirement. In the absence of a minimum amount of required TLAC, the equityholders of the holding company choose to exclusively rely on risky short-term debt financing when |$\overline{p}_2 < \overline{p}_2^* (\gamma, L)$|⁠. Therefore, when |$\overline{p} _2 < \overline{p}_2^* (\gamma, L)$|⁠, a minimum TLAC requirement is necessary as a complement to both SPOE and MPOE resolution.

Proposition 1 shows that when the asymmetric information friction is sufficiently severe, the equilibrium financing choice of the bank holding company is risky short-term debt. Essentially, when |$\overline{p}_{2}$| is sufficiently low relative to the benefits of safe short-term debt and the bank’s liquidation value, the shareholders of a bank with high continuation value (⁠|$C_{2}=V$|⁠) find it optimal to risk liquidation at date 1 and lose the benefit of safe short-term debt financing in order to escape the discount associated with long-term financing.1From a social perspective, exclusive reliance on short-term debt when |$\overline{p}_{2}<\overline{p}_{2}^{\ast }(\gamma ,L)$| is inefficient. Risky short-term debt has no social benefit (whenever funding is possible with short-term debt, it is also possible with sufficient loss-absorbing capital). Yet risky short-term debt has a social cost, because it leads to inefficient liquidation in the bad state and eliminates the social value of safe short-term debt securities.