Unbounded Liabilities, Reserve Capital Requirements and the Taxpayer Put Option

When …rms access unbounded liability exposures and are granted limited liability, then an all equity …rm holds a call option, whereby it receives a free option to put losses back to the taxpayers. We call this option the taxpayer put, where the strike is the negative of the level of reserve capital at stake in the …rm. We contribute by (i) valuing this taxpayer put, and (ii) determining the level for reserve capital without a reference to ratings. Reserve capital levels are designed to mitigate the adverse incentives for unnecessary risk introduced by the taxpayer put at the …rm level. In our approach, the level of reserve capital is set to make the aggregate risk of the …rm externally acceptable, where the speci…c form of acceptability employed is positive expectation under a concave distortion of the cash ‡ow distribution. It is observed that in the presence of the taxpayer put, debt holders may not be relied upon to monitor risk as their interests are partially aligned with equity holders by participating in the taxpayer put. Furthermore, the taxpayer put leads to an equity pricing model associated with a market discipline that punishes perceived cash shortfalls.