Government capital injection, credit risk transfer, and bank performance during a financial crisis

- This paper examines the relationships among government capital injection, credit risk transfer, and the optimal bank interest margin.
- This bank interest margin is positively related to the credit risk transfer, and to the government capital injection.
- The bank default risk is negatively related to the credit risk transfer when the bank acts as a protection buyer, and positively as a seller.
- The bank default risk is negatively related to the government capital injection.
- Government capital injection with credit risk transfer reinforces the safety for the bank during a financial turmoil.

This paper analyzes the interactions between government capital injection and credit risk transfer (CRT) with total return swaps including its impact on lending behavior and default risk of a bank in distress. When the bank acts as a beneficiary in CRT, an increase in the CRT transaction increases the optimal bank interest margin and decreases the default risk in the bank's equity return. When the bank acts as a guarantor, CRT is found to increase the bank interest margin and default risk in a more sensitive way, compared to a situation where government capital injection is increased. Government capital injection is found to increase the bank interest margin and reduce default risk in a more sensitive way, compared to a situation where CRT is increased regardless of whether the bank is a protection buyer or seller. This promotes the intension of government capital injection with CRT to strengthen the profitability and safety for the distressed bank.