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

  • Linus Wilson

    ()

  • Yan Wu
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    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. Copyright Swiss Society for Financial Market Research 2010

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    File URL: http://hdl.handle.net/10.1007/s11408-009-0125-y
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    Article provided by Springer in its journal Financial Markets and Portfolio Management.

    Volume (Year): 24 (2010)
    Issue (Month): 1 (March)
    Pages: 3-29

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    Handle: RePEc:kap:fmktpm:v:24:y:2010:i:1:p:3-29
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    1. Douglas W. Diamond & Raghuram G. Rajan, 2002. "Bank Bailouts and Aggregate Liquidity," American Economic Review, American Economic Association, vol. 92(2), pages 38-41, May.
    2. George J. Mailath & Loretta J. Mester, 1993. "A positive analysis of bank closure," Working Papers 93-10/R, Federal Reserve Bank of Philadelphia.
    3. Austan Goolsbee, 1997. "Taxes, Organizational Form, and the Deadweight Loss of the Corporate Income Tax," NBER Working Papers 6173, National Bureau of Economic Research, Inc.
    4. Tom Bernhardsen & Arne Kloster & Elisabeth Smith & Olav Syrstad, 2009. "The financial crisis in Norway: effects on financial markets and measures taken," Financial Markets and Portfolio Management, Springer, vol. 23(4), pages 361-381, December.
    5. Viral V. Acharya & Tanju Yorulmazer, 2008. "Cash-in-the-Market Pricing and Optimal Resolution of Bank Failures," Review of Financial Studies, Society for Financial Studies, vol. 21(6), pages 2705-2742, November.
    6. Janice M. Barrow & Paul M. Horvitz, 1993. "Response of Distressed Firms to Incentives: Thrift Institution Performance Under the FSLIC Management Consignment Program," Financial Management, Financial Management Association, vol. 22(3), Fall.
    7. Mark Armstrong & Simon Cowan & John Vickers, 1994. "Regulatory Reform: Economic Analysis and British Experience," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262510790, June.
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