Balancing Shareholder Value and Financial Stability under a Reduced-Form Liquidation Model

Abstract

Modern resolution and prudential regimes increasingly wind up a distressed firm not at a single hard threshold but through a graduated, state-dependent process. We study how the design of such a regime shapes the trade-off between shareholder value and financial stability for a firm whose surplus follows a general diffusion. Forced liquidation is modelled in reduced form, arriving at a surplus-dependent hazard rate that rises as the firm's position deteriorates. The framework has three regions: an unregulated region where dividends may be paid, a regulated region where solvency requirements prohibit distributions, and a distress region in which the firm faces the liquidation hazard. To quantify shareholder value we solve the resulting singular stochastic control problem: which is to maximise the expected present value of distributions until liquidation. We establish a verification theorem, prove that a barrier strategy is optimal, and obtain tractable expressions for the value function and the expected survival time, so that alternative designs can be compared at low cost. We show that a distress region placed solely below or solely above the classical ruin threshold does not consistently improve both shareholder value and firm survival, whereas combining the two yields a Pareto improvement. Regulatory design is decisive.