Common (Stock) Sense about Risk-Shifting and Bank Bailouts
Financial Markets and Portfolio Management, Vol. 24, No. 1, pp. 3-29, 2010
55 Pages Posted: 30 Dec 2008 Last revised: 15 Apr 2012
Date Written: January 1, 2010
If a bank faces potential insolvency, it will be tempted to reject good loans and accept bad loans to shift risk onto its creditors. We analyze effectiveness of buying up toxic mortgages in troubled banks, buying preferred stock, and buying common stock. If bailouts for banks that are deemed "too-big-to-fail" involve 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, whether or not 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), Leman Brothers, Public-Private Investment Program (PPIP), lending, risk-shifting, too big to fail,Troubled Asset Relief Program (TARP)
JEL Classification: G21, G28, G38
Suggested Citation: Suggested Citation