Debt Overhang and Bank Bailouts
42 Pages Posted: 24 Mar 2009 Last revised: 17 Sep 2009
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 Purchase Program, lending, preferred stock, TARP, too-big-to-fail, toxic assets
JEL Classification: G21, G28, G38
Suggested Citation: Suggested Citation