The proposed Treasury “bailout” is aimed primarily at helping banks remain solvent. In another post, I describe what bank capital is. In this post, let me try to explain why it’s important.
In my previous post on bank capital, I made the assumption my bank had $100 worth of shareholder investment (from me) that allowed me to make loans up to $1,000. I then assumed that my bank lost $200 on this loan. Let’s trace what happens next.
First, to remain a bank and not get taken over by regulators, I have two choices. One is to recognize the $200 loan loss and seek to raise an additional $200 by selling shares. The other is to do my best to prevent the $200 loan loss.
Let’s say I can’t fix the bad loan, and it’s really going to cost me $200. I now need to go issue new shares for $200, just to remain a bank. Once I raise this $200, I can remain a bank, but I can’t make any new loans, because each new dollar of loans requires me to raise an additional 10 cents. So in order to remain a bank and offer credit to my next customer, I need to really raise in excess of $200.
During a financial crisis like we’re experiencing, however, it’s very difficult to issue new shares. Many weaker banks have seen their share prices drop drastically. It’s obviously healthier to sell new shares when share prices are high. When share prices are low, there may be no way of selling enough shares to both replenish current capital and also bring in capital to support new lending.
Shortfalls in bank capital can be sudden during a meltdown, in part because mark-to-market accounting causes losses to be recognized daily.