Debt Overhang and Bank Bailouts

42 Pages Posted: 2 Feb 2009 Last revised: 17 Sep 2009

See all articles by Linus Wilson

Linus Wilson

University of Louisiana at Lafayette - College of Business Administration

Multiple version iconThere are 2 versions of this paper

Date Written: September 12, 2009


When a bank is deemed "too-big-to-fail" by regulators, it may be tempted to buy risky assets. This paper analyzes bank bailouts involving the purchases of toxic assets, preferred stock, and common stock when the government wants to encourage efficient lending. It finds that preferred stock recapitalizations are the least efficient in correcting debt overhang problems from both an ex post and ex ante perspective. In contrast, efficient lending and voluntary participation can be best achieved without subsidy by purchasing either toxic assets or common stock. Nevertheless, troubled banks must be subsidized if they will voluntarily participate in any recapitalization.

Keywords: bailout, banking, debt overhang, common stock, Capital Assistance Program, Capital Purchase Program, Emergency Economic Stabilization Act, lending, preferred stock, Public-Private Investment Partnership, PPIP, TARP, too big to fail, toxic assets

JEL Classification: G21, G28, G38

Suggested Citation

Wilson, Linus, Debt Overhang and Bank Bailouts (September 12, 2009). Available at SSRN: or

Linus Wilson (Contact Author)

University of Louisiana at Lafayette - College of Business Administration ( email )

Department of Economics & Finance
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Lafayette, LA 70504-0200
United States
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