The topic of bank default risk in connection with government bailouts has recently attracted a great deal of attention. In this paper, the question of how a bank’s default risk is affected by a distress acquisition is investigated. Specifically, the government provides a bailout program of distressed loan purchases for a strong bank to acquire a bank in distress. The acquirer bank may likely refuse the acquisition with a bailout when the amount of distressed loan purchases is large or the knock-out value of the acquired bank is high. When the acquirer bank realizes acquisition gains, the default risk in the consolidated bank’s equity return is negatively related to loan purchases, but positively to the knock-out value of the acquired bank. The government bailout, as such, in large part contributes to banking stability.

Previous research on market-based evaluation of bank equity with government bailout has modelled the bank as a corporate firm with risky assets and liabilities. No attempt was made to analyse explicitly equity quality expressed as a situation when the carrying value of the bank's equity book is above the market price, in particular, during the financial crisis. The purpose of this article is to model bank equity quality explicitly and examine the relationships between direct equity capital injections by the government and bank interest margin (and thus bank equity quality). Comparative static results with simulation exercises show that the bailout programme of direct equity injections may be efficient in terms of bank equity quality when the bailout amount is relatively small-size and the bank's interest margin is relatively low.

This article proposes a framework for bank default risk measure under government capital injection explicitly coinciding with an adverse signal that a rescued bank is expected to have significant future losses. A bank facing a serious problem of early closure may have a strong incentive to participate in a government assistance programme. Recipients of government capital injections are encouraged to make additional loans at a reduced margin, and then increase the default risk in the bank's equity returns. These results may be due to the conflicting goals of the government's capital injection programme for bank recapitalization and bank lending.

Increasing investment in human resource relative to information technology system in retail banking delivery channels increases the optimal bank interest margin and decreases the default risk in the bank’s equity returns during a financial crisis. Raising the regulatory barrier inducing a wealth transfer from shareholders to the Federal Deposit Insurance Corporation reinforces both the effects above. Human resource investment with regulatory deposit insurance fund protection as such make the distressed bank more prudent to risk-taking, thereby contributing to the stability of the banking system.

Since banks often lend via commitments, their lending and deposit-taking may be two manifestations of one primitive function: the provision of liquidity on demand. We explore this function under a cap-based valuation. We find that (i) the strike price of the cap-based valuation increases the bank's liquid asset holdings by increasing its loan rate and loan commitment rate (with the strategic rate-adjustment complements) and decreases the bank's external finance need by increasing its deposit rate, when the bank realizes a less risky state of the world and (ii) the number of caplet days decreases the bank's liquid asset holdings by decreasing its loan rate and loan commitment rate (with the strategic rate-adjustment complements and the strategic timing substitutes) and increases the bank's external finance need by decreasing its deposit rate (with the strategic timing substitutes), when the bank realizes a more risky state. Our findings provide alternative explanations concerning the bank's liquidity function under the cap-based optimization.