Government capital injection, credit risk transfer, and bank performance during a financial crisis

Abstract

This paper analyzes the interactions between government capital injection and credit risk transfer (CRT) with total return swaps including its impact on lending behavior and default risk of a bank in distress. When the bank acts as a beneficiary in CRT, an increase in the CRT transaction increases the optimal bank interest margin and decreases the default risk in the bank's equity return. When the bank acts as a guarantor, CRT is found to increase the bank interest margin and default risk in a more sensitive way, compared to a situation where government capital injection is increased. Government capital injection is found to increase the bank interest margin and reduce default risk in a more sensitive way, compared to a situation where CRT is increased regardless of whether the bank is a protection buyer or seller. This promotes the intension of government capital injection with CRT to strengthen the profitability and safety for the distressed bank.