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Bailouts, the incentive to manage risk, and financial crises

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  • Panageas, Stavros
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    Abstract

    A firm's termination leads to bankruptcy costs. This may create an incentive for outside stakeholders or the firm's debtholders to bail out the firm as bankruptcy looms. Because of this implicit guarantee, firm shareholders have an incentive to increase volatility in order to exploit the implicit protection. However, if they increase volatility too much they may induce the guarantee-extending parties to "walk away." I derive the optimal risk management rule in such a framework and show that it allows high volatility choices, while net worth is high. However, risk limits tighten abruptly when the firm's net worth declines below an endogenously determined threshold. Hence, the model reproduces the qualitative features of existing risk management rules, and can account for phenomena such as "flight to quality."

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Financial Economics.

    Volume (Year): 95 (2010)
    Issue (Month): 3 (March)
    Pages: 296-311

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    Handle: RePEc:eee:jfinec:v:95:y:2010:i:3:p:296-311

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    Web page: http://www.elsevier.com/locate/inca/505576

    Related research

    Keywords: Continuous time methods Default Implicit guarantees Risk management Bailouts;

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    Cited by:
    1. Dietrich, Diemo & Hauck, Achim, 2010. "Government interventions in banking crises: Assessing alternative schemes in a banking model of debt overhang," MPRA Paper 24508, University Library of Munich, Germany.
    2. Stavros Panageas, 2009. "Too big to fail, but a lot to bail: Optimal financing of large bailouts," 2009 Meeting Papers 175, Society for Economic Dynamics.
    3. Horvath, Balint & Huizinga, Harry, 2011. "Does the European Financial Stability Facility bail out sovereigns or banks? An event study," CEPR Discussion Papers 8661, C.E.P.R. Discussion Papers.
    4. Viral V. Acharya & Itamar Drechsler & Philipp Schnabl, 2011. "A Pyrrhic Victory? - Bank Bailouts and Sovereign Credit Risk," NBER Working Papers 17136, National Bureau of Economic Research, Inc.
    5. Deborah Lucas & Robert McDonald, 2010. "Valuing Government Guarantees: Fannie and Freddie Revisited," NBER Chapters, in: Measuring and Managing Federal Financial Risk, pages 131-154 National Bureau of Economic Research, Inc.
    6. Kuersten, Wolfgang & Linde, Rainer, 2011. "Corporate hedging versus risk-shifting in financially constrained firms: The time-horizon matters!," Journal of Corporate Finance, Elsevier, vol. 17(3), pages 502-525, June.
    7. Priyank Gandhi & Hanno Lustig, 2010. "Size Anomalies in U.S. Bank Stock Returns: A Fiscal Explanation," NBER Working Papers 16553, National Bureau of Economic Research, Inc.
    8. Marcin Kacperczyk & Philipp Schnabl, 2011. "Implicit Guarantees and Risk Taking: Evidence from Money Market Funds," NBER Working Papers 17321, National Bureau of Economic Research, Inc.
    9. Boubaker, Sabri & Nguyen, Pascal & Rouatbi, Wael, 2012. "Large shareholders and firm risk-taking behavior," MPRA Paper 39005, University Library of Munich, Germany.

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