This paper examines bank efficiency gain/loss from loan swap diversification under gov-
ernment capital injection when the borrowing firm’s risk exposure in the product market is
explicitly considered. The lending function of the bank creates specific risk characteristics
of the borrowing firm and the necessity to model the equity of the bank as a capped call
option. Using a contingent claim model of a bank-borrowing firm structure with capped call
valuation, we find that loan swap diversification leads to higher efficiency gain for the bank.
We also show that the bank increases interest margin, decreases equity risk, and increases
efficiency gain as a reaction to an increase in the government’s capital injection. Bank effi-
ciency which ignores the capped credit risk from the borrowing firm leads to loss from loan
swap diversification. In the case where the cap is ignored, an increase in the government’s
capital injection increases bank efficiency loss.
International Journal of IInformation and Management Sciences 27(3), p.217-235