January 10th, 2018
Structure of government bailout plans
Government bailouts could be varied in accordance to the consideration that the government receives for providing funds to the entity. In some cases the bailout involves the buy out of bonds or preferred stocks of the company a process that could lead to nationalization of the entity (House of Commons, 2008). In other cases the government could purchase the organizations debts which are later recovered when the organization muscles adequate resources to enable repayment. Aghion, Bolton and Fries (1999) for instance develop a model of bank bailouts based on buy out of the failing banks bad loans that is not structured on subsequent purchase of the organization’s preference stock or sub ordinate bonds (p. 69). In this model the authors argue that such debt purchases would give bank managers the required incentives to liquidate the non-performing debts (p.53). Such a move would help identify the failing institutions early enough to prevent massive degeneration that would require substantial amount of bailout funds. It has however been advanced in other studies that such purchases ought to be limited to the most minimum amounts to avoid the adverse effects these funds would have on interest rates hence on the countries currency (Weiss, & Larson, 2008). This has informed the proposal for purchase of the failing organization’s debts at their discounted fair market values.
Ideally a discounted fair market value for the purchased debt would be the best option for governments to structure its bailout plans. With such a plan the discount takes into account the poor liquidity status of the failed entities (Weiss, & Larson, 2008). The outcomes of such a plan however could defeat the purpose for which the bailout plan was instituted. The discounted market value of the debts could for instance represent a meager proportion of the entity’s total debts that the organization might in reality never recover fully to repay the amounts advanced by the public (Weiss, & Larson, 2008). This then leads to the consideration of either full payment of book value of the debts and instituting stringent managerial control to recover the funds or exploring other methods of bailouts such as conversion of the amount lent to stock of the company. A full bailout plan has for instance been argued to be ultimately beneficial in conglomerates while being unadvisable in stand alone firms (Kim, 2004). In the case of conglomerates the full bailouts would prevent the elimination of good firms thus enabling sustenance of necessary competition for growth (Kim, 2004).
A second bailout plan would involve providing financial aid to organizations through buying the stock of the company. Through such buyouts the government would influence the managerial practices by being a significant shareholder. In such cases it would be in a favorable position to review performance of the entity and have the opportunity to appoint and dismiss managers. For instance, some of the U.S bailout plans in the recent financial crisis have been through such stock buyout where the public own part of the bailed out entity through their trustee – the government (Cohan, 2009, May 31). In the UK the nationalization of Northern Rock bank following its failure is also an example of this mode of bailout (House of Commons, 2008). These bailouts of “too-big-to-fail” institutions has however been criticized on their effect on the county’s stock markets and on the behavior of such institutions and competitors in future.
Bailouts that involve the buyout of the organizations stock have been associated with a number of negative effects. One of these is an argument that these would lead to an inevitable increase in the interest rates thus aggravating the crisis the bailouts are supposed to solve (Weiss & Larson, 2008). Such bailouts also have the potential of motivating risk taking behavior by competing organizations in the banking sector (Hakenes, & Schnabel, 2009). Increased risk-taking behavior in competing organization is argued to primarily result from the high probability of the bailed out entity expanding thus heighten competitiveness of the deposit market, reducing the margins for competitors and hence inspiring risk-taking behavior (Hakenes, & Schnabel, 2009). However, a contrary finding that bailed out institutions at times take lower risks especially in instances of minimal transparency in the sector and with a significant elastic supply of deposits (Hakenes, & Schnabel, 2009) stress the need for public bailouts. Go to part 4 here.