A note on bank default risk under government capital injection coinciding with high future loss expectation

Abstract

This article proposes a framework for bank default risk measure under government capital injection explicitly coinciding with an adverse signal that a rescued bank is expected to have significant future losses. A bank facing a serious problem of early closure may have a strong incentive to participate in a government assistance programme. Recipients of government capital injections are encouraged to make additional loans at a reduced margin, and then increase the default risk in the bank's equity returns. These results may be due to the conflicting goals of the government's capital injection programme for bank recapitalization and bank lending.

Keywords:

• government capital injection
• adverse signal
• interest margin
• bank failure
• barrier

JEL Classification:

• G21
• G28

Notes

¹ We adopt the barrier option formula of Brockman and Turtle (2003) as a tool to understand the DOC approach to bank net income valuation, in which the rebate is zero.