Bank Capital, Interbank Contagion, and Bailout Policy

47 Pages Posted: 17 Apr 2013

See all articles by Suhua Tian

Suhua Tian

Fudan University - School of Economics

Yunhong Yang

Peking University - Guanghua School of Management

Gaiyan Zhang

University of Missouri at St. Louis - College of Business Administration

Date Written: April 15, 2013

Abstract

This paper develops a theoretical framework in which asset linkages in a syndicated loan agreement can infect a healthy bank when its partner bank fails. We investigate how capital constraints affect the choice of the healthy bank to takeover or liquidate the exposure held jointly with the failing bank, and how the bank’s ex ante optimal capital holding and possibility of contagion are affected by anticipation of bail-out policy, capital requirements and the joint exposure. We identify a range of factors that strengthen or weaken the possibility of contagion and bailout. Recapitalization with common stock rather than preferred equity injection dilutes existing shareholder interests and gives the bank a greater incentive to hold capital to cope with potential contagion. Increasing the minimum regulatory capital does not necessarily reduce contagion, while the requirement of holding conservation capital buffer could increase the bank’s resilience to avoid contagion.

Keywords: interbank linkages, optimal capital holding, contagion, bailout policy, regulatory capital requirement, takeover, liquidation

JEL Classification: G21, E42, L51

Suggested Citation

Tian, Suhua and Yang, Yunhong and Zhang, Gaiyan, Bank Capital, Interbank Contagion, and Bailout Policy (April 15, 2013). Journal of Banking and Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2251178

Suhua Tian

Fudan University - School of Economics ( email )

600 GuoQuan Road
Shanghai, 200433
China

Yunhong Yang

Peking University - Guanghua School of Management ( email )

Peking University
Beijing, Beijing 100871
China
8610-62768188 (Phone)

Gaiyan Zhang (Contact Author)

University of Missouri at St. Louis - College of Business Administration ( email )

One University Blvd
St. Louis, MO 63121
United States

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