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Mortgages G33 – Bankruptcy

The cash flow at date |$2$| summarizes the continuation (or franchise) value of the two subsidiaries. We assume that with probability |$p_{2}^{i}$| the operating subsidiary in jurisdiction |$i$| receives a positive continuation value of |$C_{2}=V$|⁠.8With probability |$1-p_{2}^{i}$|⁠, the continuation value is zero (⁠|$C_{2}=0$|⁠). The probability |$p_{2}^{i}$| of receiving the continuation value |$V$| is private information of the bank, both at date 0 and at date 1. For simplicity, we assume that |$p_{2}^{i}\in \{0,1\}$| and that uninformed investors’ belief that |$p_{2}^{i}=1$| is given by |$\overline{p}_{2}$| (again, both at date 0 and at date 1). Like in, the assumption that |$p_{2}^{i}$| is private information implies that it is expensive for a bank with high |$p_{2}^{i}$| to raise funds against the continuation cash flows at date |$2$|⁠. This is why long-term debt and equity are expensive funding sources relative to short-term debt.

When an operating subsidiary is unable to repay or roll over its short-term debt at date 1, short-term creditors run on the bank’s short-term liabilities and the bank is liquidated at date |$1$|⁠.9 We assume that liquidation is inefficient, in the sense that the liquidation payoff |$L$| is strictly smaller than the market’s expected value of the banking franchise, |$L<\overline{p}_{2}V$|⁠.