I'm not sure if that would really mitigate the too big to fail. If other financial institutions are holding these investment grade bonds and the bank fail I think we're just going to see a domino effect. The other financial institution that were holding the bonds are now going to have a big hole in their balance sheet and that could then make them insolvent.
So the primary bank that failed might still be standing but you'll have many other institution getting hit pretty hard because what they considered safe capital just vanished.
That's correct. The regulators are still playing with these rules but two things will mitigate that:
1. Banks are not allowed to have a too large exposure to a single counterparty, so the bail-in of a single bank should never result in another bank failing.
2. The investment in regulatory capital or in bail-inable bank capital is likely to be treated in a very penal way from a capital point of view.
Banks do have this exposure naturally as they tend to be market makers for other banks paper, so typically always hold some inventory of these bonds, but these are relatively small amounts. Banks should normally not hold large positions in other banks capital and debt as these instruments are not eligible for their liquidity pools.
So the primary bank that failed might still be standing but you'll have many other institution getting hit pretty hard because what they considered safe capital just vanished.