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

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  • Linus Wilson
  • Yan Wu

Abstract

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

Suggested Citation

  • Linus Wilson & Yan Wu, 2010. "Common (stock) sense about risk-shifting and bank bailouts," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 24(1), pages 3-29, March.
    • Handle: RePEc:kap:fmktpm:v:24:y:2010:i:1:p:3-29
    DOI: 10.1007/s11408-009-0125-y
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    References listed on IDEAS

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    More about this item

    Keywords

    Asset substitution; Banks; Bailout; Capital Assistance Program (CAP); Capital Purchase Program (CPP); Capital structure; Emergency Economic Stabilization Act (EESA); Lehman Brothers; Public-Private Investment Program (P-PIP); Lending; Risk-shifting; Too big to fail; Troubled Asset Relief Program (TARP); G21; G28; G38;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation

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