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Bank Bailout Menus

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  • Sudipto Bhattacharya

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  • Kjell G. Nyborg

Abstract

Bailing 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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File URL: http://www.lse.ac.uk/fmg/workingPapers/discussionPapers/DP668_2010_BankBailourMenus%20.pdf
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Bibliographic Info

Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp668.

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Date of creation: Jan 2011
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Handle: RePEc:fmg:fmgdps:dp668

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Web page: http://www.lse.ac.uk/fmg/

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  1. Myers, Stewart C. & Majluf, Nicholas S., 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Journal of Financial Economics, Elsevier, vol. 13(2), pages 187-221, June.
  2. Dorothea Schäfer & Klaus Zimmermann, 2009. "Bad bank(s) and the recapitalisation of the banking sector," Intereconomics: Review of European Economic Policy, Springer, vol. 44(4), pages 215-225, July.
  3. Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  4. Stewart C. Myers & Nicholas S. Majluf, 1984. "Corporate Financing and Investment Decisions When Firms Have InformationThat Investors Do Not Have," NBER Working Papers 1396, National Bureau of Economic Research, Inc.
  5. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
  6. Huberman, Gur, 1984. " External Financing and Liquidity," Journal of Finance, American Finance Association, vol. 39(3), pages 895-908, July.
  7. Augustin Landier & Kenichi Ueda, 2009. "The Economics of Bank Restructuring: Understanding the Options," IMF Staff Position Notes 2009/12, International Monetary Fund.
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Cited by:
  1. 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.
  2. Michael Brei & Leonardo Gambacorta & Goetz von Peter, 2011. "Rescue packages and bank lending," BIS Working Papers 357, Bank for International Settlements.
  3. Anat R. Admati & Peter M. DeMarzo & Martin F. Hellwig & Paul Pfleiderer, 2013. "The Leverage Ratchet Effect," Working Paper Series of the Max Planck Institute for Research on Collective Goods 2013_13, Max Planck Institute for Research on Collective Goods.
  4. Mike Mariathasan & Ouarda Merrouche, 2012. "Recapitalization, credit and liquidity," Economic Policy, CEPR & CES & MSH, vol. 27(72), pages 603-646, October.
  5. Max Bruche & Gerard Llobet, 2011. "Walking Wounded or Living Dead? Making Banks Foreclose Bad Loans," FMG Discussion Papers dp675, Financial Markets Group.
  6. Thomas Philippon & Philipp Schnabl, 2011. "Informational Rents, Macroeconomic Rents, and Efficient Bailouts," NBER Working Papers 16727, National Bureau of Economic Research, Inc.
  7. Eijffinger, Sylvester C W & Nijskens, Rob, 2011. "Complementing Bagehot: Illiquidity and insolvency resolution," CEPR Discussion Papers 8603, C.E.P.R. Discussion Papers.

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