Abstract
The topic of bank default risk in connection with government bailouts has recently attracted a great deal of attention. In this paper, the question of how a bank’s default risk is affected by a distress acquisition is investigated. Specifically, the government provides a bailout program of distressed loan purchases for a strong bank to acquire a bank in distress. The acquirer bank may likely refuse the acquisition with a bailout when the amount of distressed loan purchases is large or the knock-out value of the acquired bank is high. When the acquirer bank realizes acquisition gains, the default risk in the consolidated bank’s equity return is negatively related to loan purchases, but positively to the knock-out value of the acquired bank. The government bailout, as such, in large part contributes to banking stability.
Highlights
During a financial crisis, strategic bailout decisions often need to be taken by a government to resolve distress
What distinguishes our work from this literature is our focus on the commingling of the assessment of an acquirer bank with the assessment of an acquisition incentive and, in particular, the emphasis we put on the relationships among government incentivized assistance, early bank closure, and default risk in the context of bank interest margins with strategic distress acquisition
Once the bank has an incentive to participate in the program of government assistance to acquire a distressed bank, our result suggest that loan purchases occurs in a manner consistent with lower default risk, thereby lowering financial distress costs
Summary
Strategic bailout decisions often need to be taken by a government to resolve distress. We emphasise that the government provides, for example, a bailout program of loan purchases in order to incentivize the strong bank to acquire the distressed bank. Both the Mullins and Pyle (1994) and Episcopos (2008) approaches to valuing the bank’s equity are based on a critical assumption that loan markets faced by banks are assumed to be perfectly competitive. Fourth, increasing the knock-out value generates an increase in the default risk in the consolidated bank’s equity return due to the increased distress costs Acquisition as such makes the consolidated bank less prone to risk-taking, thereby contributing to banking stability.
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