Journal of Banking Finance 37(2013)2765-2778 Contents lists available at SciVerse Science Direct Banking Financ ELSEVIER journalhomepagewww.elsevier.com/locate/jbf Bank capital, interbank contagion, and bailout policy Cross Mark Suhua Tian, Yunhong Yang Gaiyan Zhang.* 200433 China Peking University, 5 Yiheyuan Road, Beijing 100871, China College of Business Admin University of missouri at St Louis, One University Blvd. St Louis, Mo 63121, USA A INFO ABSTRACT This paper develops a theoretical framework in which asset linkages in a syndicated loan eceived 9 February 2011 althy bank when its partner bank fails. We investigate how capital constraints vailable online 13 April 2013 of the healthy bank to takeover or liquidate the exposure held jointly with the failing ba bank's ex ante optimal capital holding and possibility of contagion are affected by anticipa EL classification: policy, capital requirements and the joint exposure. We identify a range of factors tha weaken the possibility of contagion and bailout. Recapitalization with common stock rather than pre- ferred equity injection dilutes existing shareholder interests and gives the bank a greater incentive to L51 Id capital to cope with potential contagion. Increasing the minimum regulatory capital does not nec. ssarily reduce contagion, while the requirement of holding conservation capital buffer could increase the bank,'s resilience to avoid contagion e 2013 Elsevier B V. All rights reserved. pital holding egulatory capital requirement Liquidation 1 Introduction extent banks can absorb external shocks internally during a financial crisis. Improved understanding of this issue can help the authorities There is a longstanding and ongoing debate about whether gov- better balance the benefits of government bailout, in containing the ernment bailout is necessary during a financial crisis and, if so, in contagion of a financial crisis, from its substantial costs what form it should be provided Some believe that government In this paper, we develop a theoretical framework in which a bailout of banks will save banks and their projects, minimizing a healthy bank(Bank 1)can become infected when its partner bank domino effect in the financial system and the loss of employment:( Bank 2) in a joint exposure to a syndicated loan fails and defaults Bailing out Wall Street bankers is necessary to keep the Us economy on its share of loan. We analyze the impact of Bank 1s capital hold from crumbling even further and taking American workers down with ing and the size of its exposure on contagion or continuation of it "(Barack Obama, US president, 29 September 2008). nt exposures. Furthermore, we investigate how Bank 1's capital However, others believe that banks can self-adjust, finding a prior to the crisis and possibility of contagion are affected by antic new equilibrium without help from the government: " Bailout is ipated bailout and regulation policies and a number of important not necessary. The banking industry can handle this mess intemally factors related to Bank I's exposure. and does not need subsidies. "(Bert Ely, a leading expert on banking Our study employs the inventory theoretic framework of bank and finance in the washington policy community, 24 September capital, which advocates that banks maintain a buffer of capital in Therefore, the banks'ability to self-adjust plays a key role in gov- ernment bailout decisions. Given the potential drawbacks of govern es the federal budget deficit and may even drag the untry into a fiscal crisis. Hellmann et al (2000) cite a world Bank study showing ment bailout, it is important to understand whether and to what that the costs related to financial crises can reach 40 percent of GDP. During the 2008 nder the Troubled Asset Relief Program(TARP) European governments interven Corresponding author. Tel +1 314 516 6269: fax: +1 314 516 6600. ailaddresses:tiansuhua@fudan.edu.cn(STian)yhyang@gsm.pku.edu.cn(Y Dexia by Belgium, France, and Luxembourg(E150 billion). Hypo Real Estate Bank by Yang), zhangga@umsledu(G. Zhang) Germany(E50 billion), ING by Dutch government(E35 billion), and others 0378-4266s- see front matter o 2013 Elsevier B V. All rights reserved. http://dx.doiorg/10.1016j-jbankfin.2013.03.024Bank capital, interbank contagion, and bailout policy Suhua Tian a , Yunhong Yang b , Gaiyan Zhang c,⇑ a School of Economics, Fudan University, 600 Guoquan Road, Shanghai 200433, China bGuanghua School of Management, Peking University, 5 Yiheyuan Road, Beijing 100871, China c College of Business Administration, University of Missouri at St. Louis, One University Blvd., St. Louis, MO 63121, USA article info Article history: Received 9 February 2011 Accepted 20 March 2013 Available online 13 April 2013 JEL classification: G21 E42 L51 Keywords: Interbank linkages Optimal capital holding Contagion Bailout policy Regulatory capital requirement Takeover Liquidation abstract This paper develops a theoretical framework in which asset linkages in a syndicated loan agreement can infect a healthy bank when its partner bank fails. We investigate how capital constraints affect the choice of the healthy bank to takeover or liquidate the exposure held jointly with the failing bank, and how the bank’s ex ante optimal capital holding and possibility of contagion are affected by anticipation of bail-out policy, capital requirements and the joint exposure. We identify a range of factors that strengthen or weaken the possibility of contagion and bailout. Recapitalization with common stock rather than pre￾ferred equity injection dilutes existing shareholder interests and gives the bank a greater incentive to hold capital to cope with potential contagion. Increasing the minimum regulatory capital does not nec￾essarily reduce contagion, while the requirement of holding conservation capital buffer could increase the bank’s resilience to avoid contagion. 2013 Elsevier B.V. All rights reserved. 1. Introduction There is a longstanding and ongoing debate about whether gov￾ernment bailout is necessary during a financial crisis and, if so, in what form it should be provided. Some believe that government bailout of banks will save banks and their projects, minimizing a domino effect in the financial system and the loss of employment: ‘‘Bailing out Wall Street bankers is necessary to keep the US economy from crumbling even further and taking American workers down with it.’’ (Barack Obama, US president, 29 September 2008). However, others believe that banks can self-adjust, finding a new equilibrium without help from the government: ‘‘Bailout is not necessary. The banking industry can handle this mess internally and does not need subsidies.’’ (Bert Ely, a leading expert on banking and finance in the Washington policy community, 24 September 2008). Therefore, the banks’ ability to self-adjust plays a key role in gov￾ernment bailout decisions. Given the potential drawbacks of govern￾ment bailout, it is important to understand whether and to what extent banks can absorb external shocks internally during a financial crisis. Improved understanding of this issue can help the authorities better balance the benefits of government bailout, in containing the contagion of a financial crisis, from its substantial costs.1 In this paper, we develop a theoretical framework in which a healthy bank (Bank 1) can become infected when its partner bank (Bank 2) in a joint exposure to a syndicated loan fails and defaults on its share of loan. We analyze the impact of Bank 1’s capital hold￾ing and the size of its exposure on contagion or continuation of joint exposures. Furthermore, we investigate how Bank 1’s capital prior to the crisis and possibility of contagion are affected by antic￾ipated bailout and regulation policies and a number of important factors related to Bank 1’s exposure. Our study employs the inventory theoretic framework of bank capital, which advocates that banks maintain a buffer of capital in 0378-4266/$ - see front matter 2013 Elsevier B.V. All rights reserved. http://dx.doi.org/10.1016/j.jbankfin.2013.03.024 ⇑ Corresponding author. Tel.: +1 314 516 6269; fax: +1 314 516 6600. E-mail addresses: tiansuhua@fudan.edu.cn (S. Tian), yhyang@gsm.pku.edu.cn (Y. Yang), zhangga@umsl.edu (G. Zhang). 1 Government bailout increases the federal budget deficit and may even drag the country into a fiscal crisis. Hellmann et al. (2000) cite a World Bank study showing that the costs related to financial crises can reach 40 percent of GDP. During the 2008 global financial crisis, the US government spent $250 billion to recapitalize the banks under the Troubled Asset Relief Program (TARP). European governments intervened to rescue financial institutions, such as Fortis by the Benelux countries ($16 billion), Dexia by Belgium, France, and Luxembourg (€150 billion), Hypo Real Estate Bank by Germany (€50 billion), ING by Dutch government (€35 billion), and others. Journal of Banking & Finance 37 (2013) 2765–2778 Contents lists available at SciVerse ScienceDirect Journal of Banking & Finance journal homepage: www.elsevier.com/locate/jbf