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Linda Schilling – "Too many voters to fail"
CREST Microeconomics Seminar :
Date: 15th April 2019
Place: Room 3105.
Linda Schilling – “Too many voters to fail”
Abstract: Bank failures and subsequent bank resolutions are politically important events. Politicians are sensitive to outcomes of bank resolution especially during election time when bank investors at risk of losing money are also voters. The bank investors’ threat to change voting behavior in the upcoming election yields power towards local politicians to press for bail-outs. This kind of bargaining for bail-outs is fruitful since transnational bank resolution directives leave discretion at the hands of national politicians when resolving banks. This paper provides a novel theory in which a bank’s capital structure not only describes the source of her financing but also the anticipated strength of her investors’ bargaining power should the bank fail in the future. Contrary to the existing literature, bank stability improves in debt financing if bargaining power for bailouts grows sufficiently fast. This is since bail-outs act like deposit insurance. The bank exploits the double role of her investors to boost shareholder value by trading on her creditors’ bargaining power, i.e. by strategically setting the number of voters at risk. Depositors are willing to accept a discount on the interest rate on their debt contract in return for an increase in the bank’s debt ratio. By this, the bank manages to divert part of the bail-out payable in future states where she fails into good states in which she survives. In particular, incentives of the bank and her debt investors to maximize leverage are aligned against the taxpayer.
Alexis Larousse (CREST)
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