At the height of the 2007-2009 subprime crisis, the Federal Deposit Insurance Corporation (FDIC) has shown, once again, latitude and laxity in resolving and closing insolvent institutions. Rather than automatically close insolvent systemically important financial institutions (SIFI), the FDIC revived them by infusing funds into them.
Ronn and Verma (1986) call the tolerance level below which a bank closure is triggered the regulatory policy parameter. We derive a model in which we make this policy parameter stochastic and bank-specific to infer the stock market view of the regulatory capital forbearance value. Our two-factor structural model, in which the regulatory policy parameter is modeled as an exponential of a negative Cox-Ingersoll-Ross (CIR) process, yields a closed-form solution for banks’ equity. For over 700 U.S. listed banks from 1990 to 2012, we link the model-derived forbearance fraction in equity capital to bank specific risk variables and business cycles. This forbearance fraction in capital represents 17%, on average, of the market valuation of bank equity and can go as high as 100%. We find that the market, naturally, expects banks to receive more capital forbearance in recessions. The market expectations of bank regulatory forbearance are also congruent with banks’ intrinsic owner-contributed capital, idiosyncratic risk, systemic risk, and charter value.