Debt Forgiveness and Stock Price Reaction of Lending Bank: Theory and Evidence from Japan


We provide a simple model for analyzing how debt forgiveness affects the stock price of a lending bank. Our model shows that while debt forgiveness increases the shareholders’ wealth of the bank in healthy financial conditions, it decreases the shareholders’ wealth of the bank in unhealthy financial conditions. We empirically investigate the announcement effect of debt forgiveness on bank stock prices in Japanese markets. On average, lending banks experience a significant negative announcement effect with respect to debt forgiveness. Consistent with the prediction of the model, we find a negative relationship between the announcement effect and the bad loan ratio as a proxy of the unhealthiness of bank financial conditions.

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