Bank Bailout Menus
AbstractBailing out banks requires overcoming debt overhang as well as dealing with adverse selection with respect to the quality of banks' balance sheets, in terms of heterogeneity in both the likelihood and extent of their potential shortfalls, of future asset values vis-à-vis contractual debt obligations. We examine bailouts that eliminate debt overhang, while attempting to minimize subsidies to banks' equity holders. When banks do not differ with respect to the extent of debt overhang, it can be fully overcome with the minimal amount of subsidies, providing each bank's equity holders no more than their pre-bailout values, with a partial new equity injection, or an asset buyout. When levels of debt overhang co-vary with underlying probabilities of default, we characterize the conditions for attaining a similar minimal subsidy outcome, with a Menu of either equity injection or asset buyout plans, satisfying suitable self-selection constraints among bank types. These involve global rather than local conditions, with multiple intersections of indifference curves among types, and imply strictly greater funds injections than those needed to make existing debt default free. We also explore the role of coupling asset purchases with providing the bailout agency Options to buy bank equity, to enhance its capture of rents arising from new investments by banks. We compare its performance with equity injections on this dimension, as well as others such as post-bailout stakes held by prior inside equity holders of banks.
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Bibliographic InfoPaper provided by Financial Markets Group in its series FMG Discussion Papers with number dp668.
Date of creation: Jan 2011
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Web page: http://www.lse.ac.uk/fmg/
Other versions of this item:
- Sudipto BHATTACHARYA & Kjell G. NYBORG, 2010. "Bank Bailout Menus," Swiss Finance Institute Research Paper Series 10-24, Swiss Finance Institute.
- Sudipto Bhattacharya & Kjell G. Nyborg, 2011. "Bank Bailout Menus," FMG Discussion Papers dp676, Financial Markets Group.
- Bhattacharya, Sudipto & Nyborg, Kjell G, 2010. "Bank Bailout Menus," CEPR Discussion Papers 7906, C.E.P.R. Discussion Papers.
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- G01 - Financial Economics - - General - - - Financial Crises
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
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