Title: Debt overhang and bank bailouts

Authors: Linus Wilson

Addresses: B.I. Moody III College of Business, Department of Economics and Finance, University of Louisiana at Lafayette, Lafayette, LA 70504 4570, USA

Abstract: When a bank is deemed 'too big to fail' by regulators, it may be tempted to buy risky assets. This paper analyses bank bailouts involving the purchases of toxic assets, preferred stock and common stock when the government wants to encourage efficient lending. It finds that preferred stock recapitalisations are the least efficient in correcting debt overhang problems from both an ex post and ex ante perspective. In contrast, efficient lending and voluntary participation can be best achieved without subsidy by purchasing either toxic assets or common stock. Nevertheless, troubled banks must be subsidised if they will voluntarily participate in any recapitalisation.

Keywords: bank bailouts; banking; debt overhang; common stock; capital assistance program; capital purchase program; Emergency Economic Stabilization Act; lending; preferred stock; PPIP; public-private investment partnerships; TARP; too big to fail; toxic assets; efficient lending; voluntary participation; recapitalisation.

DOI: 10.1504/IJMEF.2012.052512

International Journal of Monetary Economics and Finance, 2012 Vol.5 No.4, pp.395 - 414

Received: 29 Oct 2012
Accepted: 12 Nov 2012
Published online: 06 Mar 2013 *

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