Common (Stock) Sense about Risk-Shifting and Bank Bailouts
Linus Wilson and Yan Wendy Wu
published: 2010 | Research publication | Refereed Journals
Linus Wilson and Yan Wendy Wu, “Common (Stock) Sense about Risk-Shifting and Bank Bailouts”, Financial Markets and Portfolio Management, Vol 24 (1), 3-29. Lead Article
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.
revised Jul 8/10
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