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

Linus Wilson () and Yan Wendy Wu

Financial Markets and Portfolio Management, 2010, vol. 24, issue 1, 3-29

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

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 (search for similar items in EconPapers)
Date: 2010
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Citations: View citations in EconPapers (28)

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DOI: 10.1007/s11408-009-0125-y

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