The Carrot and the Stick: Bank Bailouts and the Disciplining Role of Board Appointments

Abstract

This paper empirically examines the Capital Purchase program (CPP) under TARP that was usedby the U.S. government to bail out distressed banks with equity infusions. We hypothesize that a feature of the CPP, namely the ability of the government to appoint directors on the assisted bank’s board in case it missed six quarterly dividend payments, was a governance intrusion that banks would wish to avoid. Therefore, it would address both (i) the ex ante moral hazard that banks would take actions that increased the likelihood of a future government bailout as well as (ii) the ex post moral hazard that banks would undertake actions after receiving bailout funding that would increase the government’s risk exposure. We find evidence consistent with this hypothesis: in the empirical distribution of missed payments there is a sharp discontinuity at five and the probability of a sixth missed payment after missing five payments is sharply lower than the other transition probabilities. The appointment of government directors improves the bank’s profitability and reduces its risk. As a special case, the firing of Citicorp’s CEO in the third quarter of 2012 after the appointment of new directors on its board, pursuant to government participation in its common equity, induced a sharp exodus of assisted banks from the CPP.