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.