Assessing bank equity risk under Legacy Loan Program

We study the effects of purchasing distressed loan on bank equity risk under the Legacy Loan Program (LLP), in which the government is in partnership with private investors. The bank may refuse LLP when its knock-out value is too low. When the bank decides to participate in the LLP, the participation of a private investor generates a decrease in bank interest margin and an increase in equity risk, but the knock-out value with the LLP assistance generates an increase in bank interest margin and a decrease in equity risk. Our results suggest that the success of LLP depends critically on the willingness of a weak bank to participate in it. However, the participation of a private investor in LLP does not decrease the weak bank’s equity risk but poses instability to the banking system.