Unlimited Liabilities, Reserve Capital Requirements and the Taxpayer Put Option

Abstract

When firms access unbounded liability exposures and are granted limited liability, then an all equity firm holds a call option, whereby it receives a free option to put losses back to the taxpayers. We call this option the taxpayer put, where the strike is the negative of the level of reserve capital at stake in the firm. We contribute by (i) valuing this taxpayer put, and (ii) determining the level for reserve capital. Reserve capital levels are designed to mitigate the adverse incentives for unnecessary risk introduced by the taxpayer put at the firm level. In our approach, the level of reserve capital is set to make the aggregate risk of the firm externally acceptable, where the specific form of acceptability employed is positive expectation under a concave distortion of the cash flow distribution. It is observed that in the presence of the taxpayer put, debt holders may not be relied upon to monitor risk as their interests are partially aligned with equity holders by participating in the taxpayer put. Further, it leads to an equity pricing model associated with a market discipline that punishes perceived cash shortfalls.

Keywords: Concave Distortions, Spread Options, Correlated Levy Processes

JEL Classification: G1, G12, G13