The economic team in Washington is finally starting to realize that the financial crisis is a capital crisis, not a liquidity crisis. But they still don't fully understand what that means. If they did, they would drop the plan to buy bank shares and focus on removing distressed assets from the banks as soon as possible.
Here's why. Capital is the difference between the value of assets and the value of liabilities -- what you own, less what you owe. Every business needs to have adequate capital, but banks are especially dependent on it.
Banks earn a living by continually borrowing money from various sources for short periods of time and then lending the money on to others at a higher rate. Every single day, a bank must convince the market it will repay what it borrows, in full and on time.
Capital is the bank's proof it can do this, because capital functions as insurance. It is the pool of resources that a bank holds in reserve to ensure it can pay off its obligations, even when the loans the bank makes to others turn bad.
If a bank's capital declines, some of its credtors will refuse to renew their existing loans to the bank, because they can't be certain the bank can repay. Unless the bank raises more capital, it will have to reduce its own lending. If the bank's capital falls to dangerously low levels, many of its creditors will stop lending at the same time, suddenly leaving the bank without even enough cash to pay its daily bills. This is a liquidity crunch for the bank that can cause it to fail.
This describes exactly what has taken place during this financial crisis. Bank capital fell because the value of what the banks owned -- subprime mortgages and other unwise investments -- plummeted. To make matters worse, the markets started to distrust the banks' own estimates of their asset values. This loss of confidence in the quality of bank capital frightened away even more lenders.
Lending to banks came to a screeching halt, and several institutions found themselves without enough cash to make their daily payments. The capital crunch produced a liquidity crunch, which is threatening more and more banks with failure.
At first, the Fed and other central banks thought that stepping in to substitute government loans for private loans would resolve the crisis. This strategy often works when liquidity shortages appear. But it has not worked in this case, because the root cause of the liquidity crunch is the capital crunch. Monetary policy can buy time for a bank by lending it enough cash to stay alive, but it cannot increase a bank's capital.
There are only two ways a bank can boost its capital. The first way is to sell new shares of its stock to investors. Cash earned on the sale of stock increases capital dollar for dollar.
The second way is by retaining profits instead of paying them out as dividends. Many banks, such as Bank of America, have cut their dividends recently for this very reason.
The Treasury is now proposing to purchase bank stocks as part of its bailout plan. But this step is premature, because it leaves the distressed assets in the banks. The bad loans were responsible for dragging capital down in the first place. As long as they stay in the banks, the market will distrust the value of the banks' capital and refuse to lend to them.
Remember that several sovereign wealth funds bought stock in big banks in late 2007, which temporarily boosted their capital. But because the bad assets remained in the banks, the capital injections from the funds were wiped out when the market lost confidence in the value of these assets.
The right approach is to buy the bad loans and investments from the banks first, and do it as quickly as possible. This will replace bad assets with good ones, like cash or Treasury securities. It also will restore confidence in the banks' remaining assets. Then, if it is still necessary, the Treasury could purchase shares in the banks.
But it is likely that once the bad assets are no longer poisoning the banks, they will have little trouble raising new capital from private investors. After the banks are truly recapitalized, private lenders will be willing to extend credit to the banks again.
The current Treasury plan runs the classic investment risk of throwing good money after bad. Why waste time and money on a plan that is likely to fail, when history shows that removing the bad assets from the banks actually works?
Connel Fullenkamp is an associate professor of economics at Duke University;
Thomas Cosimano is a professor of finance at the University of Notre Dame.