Bankruptcy which takes the form of Chapter 11 reorganization or receivership, for banks, can cure the problems of debt overhang for insolvent institutions.
Successful bankruptcy reorganizations allow organizations to reduce their debt levels and allow new private shareholders to bear enough of the gains from new investments that they will pursue new projects that have positive expected net present value.
The problem of debt overhang was used as a justification by governments to inject capital into banks around the world after the collapse of Lehman Brothers in September 2008 and the subsequent falls in stock markets worldwide.
Academic research suggests that if the government bought common stock or toxic assets in troubled banks that the debt overhang problem would be better corrected.
[4] The Congressional Review Panel Archived 2011-07-16 at the Wayback Machine, created to oversee the TARP, concluded on January 9, 2009 that, "Although half the money has not yet been received by the banks, hundreds of billions of dollars have been injected into the marketplace with no demonstrable effects on lending.
"[5] This occurs if there is a latent output gap or underemployment in an economy, which is bridged repeatedly by credit creation, the buildup of which results in a debt overhang.