Efficient Recapitalization

Abstract:     
We analyze the relative efficiency of government interventions against debt overhang when the government is either unable or unwilling to hurt long term debt holders. We first consider three interventions that have actually been used or seriously considered: buying back risky assets, injecting capital, and providing guarantees for new debt issuances. With symmetric information or compulsory participation, all the interventions are equivalent. Asset buyback and debt guarantee programs are still equivalent with voluntary participation and asymmetric information about the quality of banks' balance sheets, but they are strictly dominated by equity injections. We also find that buying back assets is the worse solution when there is adverse selection across asset classes, and that taking deposit insurance into account reduces significantly the net cost of government interventions. Finally, we show how to construct a constrained-efficient mechanism where the government makes a junior loan at a subsidized rate in exchange for call options on equity.

working papers series