Credit Default Swap, Bank Equity Return, And Default Risk Under Rescue Plan To Insurance Company

This paper aims to establish a theoretic model to explain the correlation of optimal bank interest margin with corresponding default risk in equity return, credit default swaps (CDS), government's bailout, and bank capital requirement. In 2008, when the largest insurance company in the U.S., American International Group (AIG), suffered a loss of 14 billion USD, it sought for bailouts from the U.S. government. This paper attempts to explore the effects of the large amounts of government's bailouts on the banking operations that are closely related to AIG, and understand the related impacts on financial liberalization.This study has three purposes:Purpose 1:when the government provides bailout for CDS contract provider (insurance company) that suffers from poor operation, and when the bank changes its CDS demand, what is the impact on the bank's return on equity (ROE) and corresponding default risk in equity return?Purpose 2:when the government grants bailout continuously to CDS contract provider that is in poor operation, what is the impact on the ROE of the bank, the CDS contract requester, and corresponding default risk in equity return? Purpose 3:when the government grants bailout to CDS contract provider that is in poor operation, and the financial supervisory commission changes the bank capital requirement, what is the impact on the bank's ROE and corresponding default risk in equity return? The possible answers to above three questions may serve as reference for banks, insurance companies, and financial supervisory commission.Related research methods and concepts are described as follows:First, the key to appeal is the decision on bank interest margin. According to Mercer (1992), a bank's income from interest margin could explain a significant portion of the profit, and such explanation applies to retail banking operation. Hence, the importance of interest margin management emerges again, and is closely related with return and risk issues.Second, according to Industrial Economics, structure-conduct-performance (SCP) derived profit is a kind of profit with market value characteristic or ROE, also known as the Theory of the Firm. To consider capital market risk-related characteristic, the general portfolio theory can be applied in practice. If this method is adopted to study bank risk management, then it is called portfolio-theoretic approach. This paper employs a combinational research method for consideration of both the capital market bank risk management characteristic and the bank interest margin management decision.The characteristics of this theoretic model is a portfolio structure model with call-option-based valuation (return on equity) and put-option-based valuation (insurance premium). Besides reflecting the firm-theoretic approach, this portfolio structure specifically integrates the portfolio-theoretic approach. The results indicate that, when a bank increases its CDS contract demand, its ROE will rise, but its corresponding probability of default will fall. When the government's bailout to the contract provider rises, or the government increases the bank capital requirement, the result will be contrary to the above.The paper's innovations on application are described as follows:Innovation 1:integration of conventional mean—variance portfolio theory and SCP theory of the firm enables demonstration of wider and better practicality.Innovation 2:the conventional bank interest margin management model demonstrates the decision-maker's preference in exogenous way; instead, the use of portfolio theory makes it endogenous, and valuation of bank ROE can be demonstrated by market value rather than book value.Innovation 3:the option valuation model is applied in bank ROE valuation.Innovation 4:the government's bailout mentioned in this paper is an indirect, rather than a direct, bailout; then, contract provider structural changes will occur, thus influencing the operation of the contract requester. It indicates the impact of the contract supply-demand relation on the financial system.