Efficient Recapitalization

We analyze government interventions to recapitalize a banking sector that restricts lending to firms because of debt overhang. We find that the efficient recapitalization program injects capital against preferred stock plus warrants and conditions implementation on sufficient bank participation. Preferred stock plus warrants reduces opportunistic participation by banks that do not require recapitalization, although conditional implementation limits free riding by banks that benefit from lower credit risk because of other banks’ participation. Efficient recapitalization is profitable if the benefits of lower aggregate credit risk exceed the cost of implicit transfers to bank debt holders. FIRMS INVEST TOO LITTLE if they are financed with too much debt. The reason is that the cash flow generated by new investments accrues to existing debt holders if the firm goes bankrupt. As a result, new investments can increase a firm’s debt value while reducing its equity value. A firm that maximizes equity value may therefore forgo new investment opportunities, with the extent of such underinvestment increasing as the firm gets close to bankruptcy. This is the well-known debt overhang problem first described in the seminal paper by Myers (1977). In this paper we ask whether and how a government should intervene in a financial sector that suffers from debt overhang. We focus on debt overhang in the financial sector because interactions among financial institutions can amplify debt overhang at the aggregate level. Specifically, we analyze a general equilibrium model in which lending to firms is restricted when banks suffer from debt overhang. We assume debt overhang is caused by a negative aggregate shock to bank balance sheets and analyze whether and how the government ∗Philippon and Schnabl are with New York University, NBER, and CEPR. We thank seminar participants at the 2010 American Finance Association Meeting, Baruch College, the CEPR Bank Crisis Prevention and Resolution Conference, the CEPR Gerzensee Corporate Finance Meeting, the CEPR-HSG Corporate Finance and Economic Performance Conference, the Federal Reserve Chicago Bank Structure and Competition Conference, Harvard University, the NBER Asset Pricing and Corporate Finance Meeting, the NBER Monetary Economics Program Meeting, New York University, the New York Federal Reserve Liquidity Working Group, Princeton University, the OeNB Bank Resolution Workshop, the UBC Summer Finance Conference, the University of Binghamton, the University of Chicago, and the University of Rochester, and our discussants Marco Becht, Arnoud W.A. Boot, Max Bruche, Ron Giammarino, Itay Goldstein, Adriano Rampini, Gustav Sigurdsson, Juan Sole, and Luigi Zingales for helpful comments and suggestions. We are grateful for comments from an anonymous referee, an Associated Editor, and the Editor (Campbell Harvey). An earlier version of this paper was circulated under the title “Efficient Bank Recapitalization.”