The Carrot and the Stick: Bank Bailouts and the Disciplining Role of Board Appointments

47 Pages Posted: 24 Mar 2021

See all articles by Christian Mücke

Christian Mücke

Leibniz Institute for Financial Research SAFE

Loriana Pelizzon

Goethe University Frankfurt - Faculty of Economics and Business Administration; Leibniz Institute for Financial Research SAFE; Ca Foscari University of Venice - Dipartimento di Economia

Vincenzo Pezone

Tilburg University - Department of Finance

Anjan V. Thakor

Washington University in St. Louis - John M. Olin Business School; Financial Theory Group; European Corporate Governance Institute (ECGI); Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering

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Date Written: March 22, 2021

Abstract

This paper empirically examines the Capital Purchase program (CPP) under TARP that was usedby the U.S. government to bail out distressed banks with equity infusions. We hypothesize that a feature of the CPP, namely the ability of the government to appoint directors on the assisted bank’s board in case it missed six quarterly dividend payments, was a governance intrusion that banks would wish to avoid. Therefore, it would address both (i) the ex ante moral hazard that banks would take actions that increased the likelihood of a future government bailout as well as (ii) the ex post moral hazard that banks would undertake actions after receiving bailout funding that would increase the government’s risk exposure. We find evidence consistent with this hypothesis: in the empirical distribution of missed payments there is a sharp discontinuity at five and the probability of a sixth missed payment after missing five payments is sharply lower than the other transition probabilities. The appointment of government directors improves the bank’s profitability and reduces its risk. As a special case, the firing of Citicorp’s CEO in the third quarter of 2012 after the appointment of new directors on its board, pursuant to government participation in its common equity, induced a sharp exodus of assisted banks from the CPP.

Keywords: corporate governance, directors, bank bailouts

JEL Classification: G21, G28,G34, G38

Suggested Citation

Mücke, Christian and Pelizzon, Loriana and Pezone, Vincenzo and Thakor, Anjan V., The Carrot and the Stick: Bank Bailouts and the Disciplining Role of Board Appointments (March 22, 2021). European Corporate Governance Institute – Finance Working Paper No. 742/2021, Available at SSRN: https://ssrn.com/abstract=3809689 or http://dx.doi.org/10.2139/ssrn.3809689

Christian Mücke

Leibniz Institute for Financial Research SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

Loriana Pelizzon

Goethe University Frankfurt - Faculty of Economics and Business Administration ( email )

Theodor-W.-Adorno-Platz 3
Frankfurt am Main, D-60323
Germany

Leibniz Institute for Financial Research SAFE ( email )

Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

HOME PAGE: http://www.safe-frankfurt.de

Ca Foscari University of Venice - Dipartimento di Economia ( email )

Cannaregio 873
Venice, 30121
Italy

Vincenzo Pezone

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Anjan V. Thakor (Contact Author)

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

Financial Theory Group ( email )

United States

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering ( email )

100 Main Street, E62-618
Cambridge, MA 02142
United States

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