Debt-equity swaps, regulation K, and bank stock returns

Abstract

Since the early 1980s, the financial health of several highly levered LDCs has become increasingly precarious. Their financial problems, in turn, imply potentially serious financial problems for their creditors, foremost among whom are some of the largest banks in the American financial system. In order to relieve some of the pressure on the lending firms, the Board of Governors has recently amended Regulation K, which provides guidelines for international banking operations, to allow for unrestricted investment in foreign nationalized firms through the mechanism of the debt-equity swap. This paper examines the capital market reaction to the regulatory change and we find that (1) investors, on average, viewed the change as a wealth-increasing event, (2) the magnitude of the market reaction was significant and positively related to the level of foreign lending exposure, and (3) among LDC lenders, the capital market reaction differed significantly between money-center and non-money-center banks.