S. Tian et al Jourmal of Banking 8 Finance 37(2013)2765-2778 2773 able 3 illustrates the impact of the anticipated probability of Bank Is bargaining power, x, and the optimal capital holding s =0.5, 2=0.5, 1=02, the government bailout. When the probability of bailout goes from n=1,y=1,t=0.10.÷=0.50. 0.1 to 0.9, Ce decreases by $18.2 million from $.4008 billion to S103826 billion, while Com decreases by a smaller amount of $15.8 million from $.401 billion to $.3852 billion. The higher the 117935 anticipated probability of the government bailout, the lower the ex ante capital holding Bank 1 will maintain, and the greater 000295751 amount of bailout will be needed, reflecting the moral hazard Next, we examine in Table 4 the impact on contagion and bailout amounts if the public policy on capital requirement is changed. The avoid contagion when the crisis materializes. This underscores the ecently finalized Basel Ill requires banks to hold 4.5% of common ontagion. To help Bank 1 to reach the new optimal capital level that 4%)of risk-weighted assets. Basel lll also introduces an additional maximizes its shareholder's value, the government needs to inject capital conservation buffer of 2.5%, which is designed to ensure that 3.265 billion(Kipre)and 0.46 billion(K om)in the case of preferred banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred and to avoid breaches of mini- ital holdingfor an anticipated common equity bailout allows a lower mum capital requirements. our simulation shows that increasing level of government recapitalization. tagion, in fact, this could increase contagion. But imposing the con- Contagion is more likely to occur if Bank 1 underestimates servation buffer as Basel ll could help banks to increase resilience probability of crisis. For example, when o is 0.9(Com is 14. 1071 bil As shown in Table 4, when t is 0.08, both Ce and Com are great lion) but Bank 1 estimates the shock intensity to be 0.3, Com er than 0.08, no contagion will occur. However, if the authority (11.7928 billion) will be lower than C, thus contagion occurs. The government needs to inject an amount of 2.779 billion rather creases t(0.09, 0.10, 0.11 or 0.12), contagion could occur under the anticipated preferred stock bailout because C goes up by a higher than 0.465 billion if Bank 1 correctly estimated the shock intensity level than C:. Similarly, contagion will occur when increases to fo.9. An unexpected external shock is more likely to cause inter 0.10.0.11 or 0.12 under the bank contagion and large bailout requirements, as shown in recent in the last two rows, K and K"om increase with T, suggesting that financial crisis imply increasing minimum capital requirement is not a cure-all d=05=05k=01n=1x010y=096r=0.10.E=050 =05=05k01n=2x010y=096r=0.10.5=050 c=c;"c-即*n-)-m -g+n01-y)-m a C<c<c<c b)C<C<C<c =05=050.1,n=1x0.0y=096r=0.10=0.50 4=05=05k01n=2x0.10y=096r=010.=050 Equity Vale U(C-[Q+nXl-y)-mmD (cC<c<c d Fig. 2. Bank 1's pre-crisis and post-crisis value functions. Note: (a)and(b)shows Bank I's pre-crisis and post-crisis value functions with the anticipated preferred stock allout; (c)and (d) shows Bank 1's pre-crisis and post-crisis value functions with the anticipated preferred stock bailoutavoid contagion when the crisis materializes. This underscores the importance of keeping capital buffer in anticipation of interbank contagion. To help Bank 1 to reach the new optimal capital level that maximizes its shareholder’s value, the government needs to inject 3.265 billion K pre  and 0.46 billion K com   in the case of preferred and common stock bailout, respectively. Bank 1’s more ex ante cap￾ital holding for an anticipated common equity bailout allows a lower level of government recapitalization. Contagion is more likely to occur if Bank 1 underestimates probability of crisis. For example, when / is 0.9 (C com is 14.1071 bil￾lion) but Bank 1 estimates the shock intensity to be 0.3, C com (11.7928 billion) will be lower than b C, thus contagion occurs. The government needs to inject an amount of 2.779 billion rather than 0.465 billion if Bank 1 correctly estimated the shock intensity of 0.9. An unexpected external shock is more likely to cause inter￾bank contagion and large bailout requirements, as shown in recent financial crisis. Table 3 illustrates the impact of the anticipated probability of the government bailout. When the probability of bailout goes from 0.1 to 0.9, C pre decreases by $18.2 million from $10.4008 billion to $10.3826 billion, while C com decreases by a smaller amount of $15.8 million from $10.401 billion to $10.3852 billion. The higher the anticipated probability of the government bailout, the lower the ex ante capital holding Bank 1 will maintain, and the greater amount of bailout will be needed, reflecting the moral hazard problem. Next, we examine in Table 4 the impact on contagion and bailout amounts if the public policy on capital requirement is changed. The recently finalized Basel III requires banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4%) of risk-weighted assets. Basel III also introduces an additional capital conservation buffer of 2.5%, which is designed to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred and to avoid breaches of mini￾mum capital requirements. Our simulation shows that increasing the absolute regulatory minimum will not necessarily reduce con￾tagion, in fact, this could increase contagion. But imposing the con￾servation buffer as Basel III could help banks to increase resilience. As shown in Table 4, when s is 0.08, both C pre and C com are great￾er than 0.08, no contagion will occur. However, if the authority in￾creases s (0.09, 0.10, 0.11 or 0.12), contagion could occur under the anticipated preferred stock bailout because b C goes up by a higher level than C pre. Similarly, contagion will occur when sincreases to 0.10, 0.11 or 0.12 under the anticipated common stock. As shown in the last two rows, K pre and K com increase with s, suggesting that simply increasing minimum capital requirement is not a cure-all Table 5 Bank 1’s bargaining power, x, and the optimal capital holding / = 0.5, k = 0.5, l = 0.2, n = 1, y = 1, s = 0.10, n = 0.50. x 0 0.05 0.10 0.15 0.20 b C 0.12 0.115 0.11 0.105 0.1 C pre 0.113809 0.113832 0.126471 0.12158 0.117935 C com 0.117594 0.131471 0.126476 0.121584 0.117935 K pre 0.027084 0.0220611 0.00442152 0.00431263 0.00295751 K com 0.023299 0.0044222 0.0044167 0.00430878 0.00295751 Fig. 2. Bank 1’s pre-crisis and post-crisis value functions. Note: (a) and (b) shows Bank 1’s pre-crisis and post-crisis value functions with the anticipated preferred stock bailout; (c) and (d) shows Bank 1’s pre-crisis and post-crisis value functions with the anticipated preferred stock bailout. S. Tian et al. / Journal of Banking & Finance 37 (2013) 2765–2778 2773