Common (Stock) Sense About Risk-Shifting and Bank Bailouts
University of Louisiana at Lafayette - College of Business Administration
Wilfrid Laurier University
January 16, 2010
Financial Markets and Portfolio Management, Vol. 24, No. 1, pp. 3-29, 2010
If a bank is facing insolvency, it will be tempted to reject good loans and accept bad loans so as to shift risk onto its creditors. We analyze the effectiveness of buying up toxic mortgages in troubled banks, buying preferred stock, and buying common stock. If bailing out banks deemed “too big to fail” involves buying assets at above fair market values, then these banks are encouraged ex ante to gamble on bad assets. Buying up common (preferred) stock is always the most (least) ex ante- and ex post-efficient type of capital infusion, regardless of whether the bank volunteers for the recapitalization.
Keywords: Asset substitution, Banks, Bailout, Capital Assistance Program (CAP), Capital Purchase Program (CPP), Capital structure, Emergency Economic Stabilization Act (EESA), Lehman Brothers, Public-Private Investment Program (P-PIP), Lending, Risk-shifting, Too big to fail, Troubled Asset Relief
JEL Classification: G21, G28, G38
Date posted: June 19, 2010
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