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Why Do Banks Default When Asset Quality Is High?

Author

Listed:
  • Lie-Jane Kao
  • Po-Cheng Wu
  • Tai-Yuan Chen

Abstract

Short-term financing, e.g., asset-backed commercial paper (ABCP) or repurchase agreements (repo), was prevalent prior to the 2007-2008 financial crises. Banks funded by short-term debts, however, are exposed to rollover risk as the banks are unable to raise sufficient funds to finance their long-term assets. Under such circumstance, banks’ equity holders need to absorb the rollover loss. Both deteriorating collateral assets’ fundamentals and market illiquidity are important drivers of the rollover risk. In this paper, we develop a structural default model based on Leland (1994), in which default is an endogenously determined decision made by equity holders, to analyze the joint effect of market liquidity and interest rate sensitive fundamentals of collateral assets’ on the survival times of banks relying on day-to-day short-term finance. The proposed model provides an explanation of the empirical observed phenomenon that banks default even when the quality of their fundamentals is still high.

Suggested Citation

  • Lie-Jane Kao & Po-Cheng Wu & Tai-Yuan Chen, 2012. "Why Do Banks Default When Asset Quality Is High?," The International Journal of Business and Finance Research, The Institute for Business and Finance Research, vol. 6(1), pages 83-96.
  • Handle: RePEc:ibf:ijbfre:v:6:y:2012:i:1:p:83-96
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    References listed on IDEAS

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    More about this item

    Keywords

    Asset-backed commercial paper (ABCP); Repurchase agreements (repo); Rollover risk; Collateral assets’ fundamental; Market illiquidity; Structural default model.;

    JEL classification:

    • C41 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Duration Analysis; Optimal Timing Strategies
    • C36 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Instrumental Variables (IV) Estimation
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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