Capital crisis

Starting out as sub-prime crisis, the present economic crisis is now called "credit crisis". And thats making central banks push commercial banks to begin extending credit. Presently only a moral suasion, its possible it may take form of more direct regulations soon. And this push for more bank lending (& thereby more assets) seems to be a case of "cause for disease taking the form of cure"!

But is this paradoxical solution because of the wrong name for the disease? To me, the issue is more of a 'capital crisis' rather than credit. Due to years of rather low interest rates, chase of yields, globalised flow of funds, limited regulatory supervison on capitalization & ability to get assets quickly off balance sheet - all meant that banks & instituions have put up huge amount of assets backed by limited owner's equity. And that equity has nowhere been close to sufficiency for stress losses, which is what is leaving them completely naked and inadequate now. As someone said, practically most of the western financial world is technically insolvent.

Now that high losses are happening, how do you balance the balance sheet? Someone has to fund them right? Initially, private capital did come in, as they thought sufficient first loss (expected loss) had been absorbed by the original equity holders. But unfortunately, very soon it dawned that they were only funding more losses. So that route stopped. 

And the losses continue....and someone has to fund it. Enter the Governments.....

If you look at it, due to the bubble across, all assets were overvalued. Which means correspondingly, on the other side, liabilities too were over valued. While market prices of stock can correct quickly, on the balance sheet, there is only so much equity (at book value). Which means other liability holders also have to bear the losses as well. Thats what happened to Lehman debt & bond holders. But obviously, Govt does not want deposit holders to bear these loses, as that would question the basic tenant of banking system. So, they step in to fund the losses.

As long as Govt capital is only going to fund the losses on existing assets, there is no way banks can start fresh lending. Its not a question of willingness; its a question of ability. They simply do not have sufficient capital on basis of which they can provide loans. Any impression that TARP & other governments' capital should be used for lending is an attempt to look away from the reality. And if banks are forced to do so, it would only mean they will have to capitalised again at not so distant future....remember there are losses still to be funded. 

Thats why, this is not about lack of credit. Its about lack of capital.