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Common (stock) sense about risk-shifting and bank bailouts

  • Linus WilsonEmail author
  • Yan Wendy Wu
Article

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 Program (TARP) 

JEL Classification

G21 G28 G38 

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Copyright information

© Swiss Society for Financial Market Research 2010

Authors and Affiliations

  1. 1.B.I. Moody III College of Business, Department of Economics & FinanceUniversity of Louisiana at LafayetteLafayetteUSA
  2. 2.Department of Economics, School of Business and EconomicsWilfrid Laurier UniversityWaterlooCanada

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