Assessing bank equity risk under Legacy Loan Program

Abstract

We study the effects of purchasing distressed loan on bank equity risk under the Legacy Loan Program (LLP), in which the government is in partnership with private investors. The bank may refuse LLP when its knock-out value is too low. When the bank decides to participate in the LLP, the participation of a private investor generates a decrease in bank interest margin and an increase in equity risk, but the knock-out value with the LLP assistance generates an increase in bank interest margin and a decrease in equity risk. Our results suggest that the success of LLP depends critically on the willingness of a weak bank to participate in it. However, the participation of a private investor in LLP does not decrease the weak bank’s equity risk but poses instability to the banking system.

Keywords:

• Legacy Loan Program
• barrier
• equity risk
• bank interest margin

JEL Classification:

• G21
• G28

Notes

¹ See http://www.fdic.gov/news/news/press/2009/pr09172.html.

² As pointed out by Brockman and Turtle (2003), a down-and-out call option is one type of knock-out option. Other knock-out options include the down-and-out put, up-and-out call and put-and-out put. Such concerns are beyond the scope of this article and so are not addressed here.

³ Note that there are many discussions of bank behaviour under the LLP including PPIF capital structure, selling bank application process, asset purchases and pricing, governance and management, FDIC fees and expenses and reservation of rights (see www.wipp.org/resource/resmgr/newsroom_links/legacy_loans_program_term_sh.pdf).

⁴ The capital requirement constraint will be binding as long as is sufficiently higher than (Wong, 1997).

⁵ It is recognized that banks may opt out of the government assistance alternative situations. For example, based on the Japanese experience, Hoshi and Kashyap (2010) argue that the success of a financial rescue programme depends critically on the willingness of weak banks to participate in it. Bayazitova and Shivdasani (2012) also argue that the incentives of banks to participate are reduced by the restrictions and political debate over executive compensation of government assistance programme recipients.

⁶ Hoshi and Kashyap (2010) indicate that the success of a financial rescue programme depends critically on the willingness of weak banks to participate in it. In particular, a bank may refuse government assistance if the capital injection generates an adverse signal that the bank is expected to have high future losses. Bayazitova and Shivdasani (2012) also argue that strong banks, rather than weak banks, opted out of participating in the government assistance programme. It is recognized that our approach, denoted by the bank’s participation incentive, is only an alternative.