Bailouts, the incentive to manage risk, and financial crises

Stavros Panageas

Journal of Financial Economics, 2010, vol. 95, issue 3, 296-311

Abstract: A firm's termination leads to bankruptcy costs. This may create an incentive for outside stakeholders or the firm's debtholders to bail out the firm as bankruptcy looms. Because of this implicit guarantee, firm shareholders have an incentive to increase volatility in order to exploit the implicit protection. However, if they increase volatility too much they may induce the guarantee-extending parties to "walk away." I derive the optimal risk management rule in such a framework and show that it allows high volatility choices, while net worth is high. However, risk limits tighten abruptly when the firm's net worth declines below an endogenously determined threshold. Hence, the model reproduces the qualitative features of existing risk management rules, and can account for phenomena such as "flight to quality."

Keywords: Continuous; time; methods; Default; Implicit; guarantees; Risk; management; Bailouts (search for similar items in EconPapers)
Date: 2010
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (22)

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0304-405X(09)00238-4
Full text for ScienceDirect subscribers only

Related works:
Working Paper: Bailouts, the Incentive to Manage Risk, and Financial Crises (2009)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:95:y:2010:i:3:p:296-311

Access Statistics for this article

Journal of Financial Economics is currently edited by G. William Schwert

More articles in Journal of Financial Economics from Elsevier
Bibliographic data for series maintained by Catherine Liu ().