Troubled asset relief program, bank interest margin and default risk in equity return: an option-pricing model

Will banks be willing to sell their toxic loans with the help of the Troubled Asset Relief Program (TARP)? The answer is yes as long as bids are high enough to tempt banks to deal. With the TARP's help, an increase in the toxic loans sold to the government increases the bank's margin and decreases the bank's default probability in equity return when the bank encounters greater risk. This paper concludes that setting up the TARP for the 'bad bank' solution may be a good move for retail banking, resulting in high margin and low default risk when its target banks are willing sellers.