Purpose – The purpose of this paper is to develop a capped barrier option framework to consider the
politically preferential treatment for bank loans incentivized by government capital injections and calculate
loan-risk sensitive insurance premiums.
Design/methodology/approach – This paper takes a capped barrier option approach to the market
valuation of the equity of the bank and the liability of the deposit insurer. The cap demonstrates the dynamics
of a politically connected borrowing firm’s asset and highlights the truncated nature of loan payoffs.
The barrier addresses that default can occur at any time before the maturity date. The bank participating in a
government capital injection program is required to fund the politically connected firm that has preferential
access to financing.
Findings – Political connection as such makes the bank more prone to risk taking at a reduced interest
margin, produces greater safety for the bank owing to government capital injections, and leads to increasing
the fair deposit insurance premium. The positive effect of political connection on the deposit insurance
premium, which ignores the cap and the barrier yields significant over-estimation.
Originality/value – The study on the politically connected borrowing firm shows that political connection is
likely to affect the distressed bank’s performance, yielding the political-connection cost of a reduced bank
interest margin and the political-connection benefit of a reduced bank equity risk, contributing the literature
on political connection and bank bailout.
International Journal of Managerial Finance 15(1), p.2-18