Abstract
In the recent financial crisis, reorganizations of distressed financial institutions following the good bank and bad bank model were discussed. In the context of a structural framework and under perfect information, we analyze endogenous capital structure choices of an arrangement constituted by a large regulated unit which manages the more secure assets of a bank and a smaller division - possibly unregulated - which gathers the more risky and volatile ones. We question whether such an arrangement is a priori optimal and whether financial institutions have private incentives to set up different risk-classes of assets in separate entities. We investigate the effect of intra-group guarantees on optimal leverage and expected default costs. Numerical results show that these guarantees can enhance group value and limit default costs when the firm separates its more secure from its more risky assets in regulated entities.
This is a preview of subscription content, log in via an institution to check access.
Access this chapter
Tax calculation will be finalised at checkout
Purchases are for personal use only
Notes
- 1.
The importance of the decision of how the two units are incorporated is clearly recognized by [9].
- 2.
This analysis is motivated by the fact that recently, during the Solvency II Directive proposal meetings, rules on capital transfers among members of the same group — the so called Group Support framework — have been extensively discussed.
- 3.
See [1] for a full account of the structures financial institutions can take.
- 4.
Usually, in this kind of arrangement, the units are owned by an “umbrella” holding corporation.
- 5.
Other works – see f.i. [5] – studied inter-divisional capital allocation problems under agency or asymmetric information problems. In their models, market frictions are due to underinvestment or imperfect knowledge of future cash flows’ distribution.
- 6.
We refer the reader to [7] for a discussion on the existence of such guarantees in reality, in the form of capital transfers and for an analysis of the properties of such guarantees. The rationale for their existence lies in the opportunity fot the parent company to save reputation costs due to defaulting subsidiaries and, thus, to find financing more easily in that unit.
- 7.
This kind of constraint is consistent with the current internal model Basel II/Solvency II practice. Cash flows are assumed independently and identically distributed through the years of the time horizon.
- 8.
pt plus .1ptpt plus .1ptEquity and debt values in one unit can depend on the principal issued by the other unit. In the SA case — see [6] — this does not happen and E0 and D0 are defined as
where φ is the discount factor, Xd is the level of realized gross cash flows under which default occurs, Xn denotes cash flows net of taxes and default costs and f (x) is the density of the cash flow distribution. In the HS case, the conditional rescue event makes debt and equity values in one unit dependent also on the financing choices of the other one (see [7] and [8]): their expressions and the solution to the optimization program is indeed much more complicated. - 9.
Following [6], we set the risk-free interest rate to 5% and the effective tax rate to 20%. Time horizon T is set to 10 years, which is approximately the average maturity of financial institutions’ bonds and SIVs’ assets. Exogenous cash flows are normally distributed with mean E0[X]=100. Default costs and cash flow volatility σ[X] are set respectively to 10% and 17% in order to match observed default probabilities, leverage ratios and recovery rates of Ba/B rated companies.
- 10.
Operating cash flows of the good bank are normally distributed with mean E0[XG]=μG=75 and standard deviation σ[XG=σG=14%, the bad bank ones are also normal with mean E0[XB =μB=25 and standard deviation σ[XB]=σB=36.45. This values match the ones of the original institution, which is indeed the IC of G and B.
- 11.
While an HG where both units are regulated is less valuable than the IC (84.17 vs. 84.36) the HG has higher value (84.73) than an IC that merges the good bank and an unregulated bad bank (unreported, 84.01).
- 12.
We set them to 23%, the same value used in [6] for unregulated commercial firms.
- 13.
This fact reconciles with the empirical evidence that equity tranches in SIVs account for less than 1% of the total financing of the unit.
- 14.
Rescue happens with a high probability, 44.79%.
where φ is the discount factor, Xd is the level of realized gross cash flows under which default occurs, Xn denotes cash flows net of taxes and default costs and f (x) is the density of the cash flow distribution. In the HS case, the conditional rescue event makes debt and equity values in one unit dependent also on the financing choices of the other one (see [References
Dierick, F.: The supervision of mixed financial services groups in Europe, Occasional Paper Series 20, ECB, Frankfurt (2004)
Ergungor, O.: On the resolution of financial crises: the Swedish Experience, Policy Discussion Paper 21, Federal Reserve Bank of Cleveland (2007)
Geithner, T.: My plan for Bad Bank Assets, The New York Times, March 23 (2009)
Hall, R., Woodward, S.: The right way to create a good bank and a bad bank, http://woodwardhall.wordpress.com/2009/02/23/the-right-way-to-create-a-good-bank-and-a-bad-bank/ (2009)
Kahn, C., Winton, A.: Moral hazard and optimal subsidiary structure for financial institutions, J. of Finance 59, 2531–2575 (2004)
Leland, H.: Purely financial synergies and the optimal scope of the firm: implications for mergers, spin offs, and structured finance, J. of Finance 62, 765–807 (2007)
Luciano, E., Nicodano, G.: Intercorporate guarantees, Leverage and Taxes, Working Paper Collegio Carlo Alberto (2010)
Regis, L.: Three essays in finance and actuarial sciences, Ph D Thesis, University of Torino (2010)
Santomero, A., Hoffman, P.: Problem bank resolution: evaluating the options, in B Gup (ed) International banking crises: large-scale failure, governments intervention, Greenwood Publishing Group, Westport, CT (1998)
Zingales, L.: Yes we can, Secretary Geithner, in: Economists’ voice, The Berkeley Electronic Press 6, 2(3) (2009)
Acknowledgements
I would like to thank my Ph.D. supervisor Elisa Luciano for helpful comments and discussions, Edmund Cannon for comments at the MAF 2010 conference and two anonymous referees.
Author information
Authors and Affiliations
Corresponding author
Editor information
Editors and Affiliations
Rights and permissions
Copyright information
© 2012 Springer-Verlag Italia
About this chapter
Cite this chapter
Regis, L. (2012). Good and bad banks. In: Perna, C., Sibillo, M. (eds) Mathematical and Statistical Methods for Actuarial Sciences and Finance. Springer, Milano. https://doi.org/10.1007/978-88-470-2342-0_42
Download citation
DOI: https://doi.org/10.1007/978-88-470-2342-0_42
Publisher Name: Springer, Milano
Print ISBN: 978-88-470-2341-3
Online ISBN: 978-88-470-2342-0
eBook Packages: Mathematics and StatisticsMathematics and Statistics (R0)