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Common (Stock) Sense About Risk-Shifting and Bank Bailouts

Financial Markets and Portfolio Management, Vol. 24, No. 1, pp. 3-29, 2010

Posted: 19 Jun 2010  

Linus Wilson

University of Louisiana at Lafayette - College of Business Administration

Yan Wendy Wu

Wilfrid Laurier University

Multiple version iconThere are 2 versions of this paper

Date Written: January 16, 2010

Abstract

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

Suggested Citation

Wilson, Linus and Wu, Yan Wendy, Common (Stock) Sense About Risk-Shifting and Bank Bailouts (January 16, 2010). Financial Markets and Portfolio Management, Vol. 24, No. 1, pp. 3-29, 2010. Available at SSRN: https://ssrn.com/abstract=1626369

Linus Wilson (Contact Author)

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

Department of Economics & Finance
214 Hebrard Blvd., Room 326
Lafayette, LA 70504-0200
United States
(337) 482-6209 (Phone)
(337) 482-6675 (Fax)

HOME PAGE: http://www.linuswilson.com

Yan Wendy Wu

Wilfrid Laurier University ( email )

75 University Ave W
Waterloo, Ontario N2L 3C5
Canada

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