Liquidation Risks, Investment and Bank Takeovers

Abstract

This paper studies two questions: first, what's the underlying reason for takeovers increasingly involved as one of the most popular resolution methods for bank failures; second, how do takeovers affect the investment policy of the bank. Different from previous literature, which emphasizes on the effect of takeovers on the ex-ante choice of bank managers or asset allocations to insiders, this paper focuses on bank managers' moral hazard and limited pledgeability. I find that diversified takeovers can reduce bank liquidation risks and raise the level of investment. The basic idea is that takeovers can reduce agency problem and increase income pledgeability, so investors are more willing to provide liquidity to the bank when there is a shock as well as do a large investment at initial stage. Moreover, takeovers at different time are shown to have different comparative advantages, where ex-post takeovers (takeovers after the liquidity shock) are better at reducing liquidation risks while ex-ante takeovers (takeovers before the liquidity shock) are better at increasing initial investment. It is because ex-post takeovers is better at diversifying liquidity shocks while ex-ante takeovers is better at increasing pledgeable income. In addition, when the liquidity shock can be withstood through the acquisition of the bad bank by the good bank, ex-post takeovers generate higher social values in a boom economy, whereas ex-ante takeovers generate higher social values in a bust economy. However, the investors always prefer the ex-ante takeovers, leaving a high future liquidation risk for a boom economy. This contradiction between the investors' preference and social preference indicates a role for regulation on bank takeovers during the economic boom.