Equity injections won't work
Source Marvin Gandall
Date 08/10/11/09:59

Temporary full state ownership is only solution
By Paul De Grauwe
Financial Times
October 9 2008

THE ESSENCE OF WHAT banks do in normal times is to borrow short and lend
long. In doing so, they transform short-term assets into long ones, thereby
creating credit and liquidity. Put differently, by borrowing short and
lending long, banks become less liquid, thereby making it possible for the
non-banking sector to become more liquid; that is, have assets that are
shorter than their liabilities. This is essential for the non-banking sector
to run smoothly.

This credit transformation model performed by banks only works if there is
confidence in the banks and, more importantly, if banks trust each other.
This confidence has now evaporated and, as a result, the model fails. The
generalised distrust within the banking system has led to a situation where
banks do not want to lend any more. That means that they continue to borrow
short but lend equally short; that is, acquire the most liquid assets.

The result is a massive destruction of credit and liquidity in the economy.
The non-banking sector cannot borrow long so as to acquire liquid assets
that they need to run their business, because banks do not lend long
anymore. This risks bringing the economy to a standstill. A depression is

It is important to realise that this liquidity crisis is the result of a
co-ordination failure: bank A does not want to lend to bank B, not
necessarily because it fears insolvency of bank B but because it fears other
banks will not lend to bank B, thereby creating insolvency of bank B out of
the blue. Thus bank lending comes to a standstill because banks expect bank
lending to come to a standstill.

How to get out of this bad equilibrium? There is only one way. The
governments of the big countries (US, UK, the eurozone, possibly Japan) must
take over their banking systems (or at least the significant banks).
Governments are the only institutions that can solve the co-ordination
failure at the heart of the liquidity crisis. They can do this because once
the banks are in the hands of the state, they can be ordered to trust each
other and to lend to each other. The faster governments take these steps,
the better.

Government interventions have consisted of recapitalising banks. These have
not worked. The main reason is that they have been triggered by bank
failures as they pop up and, as a result, have only dealt with the symptoms.
The liquidity crisis is pulling down asset prices in an indiscriminate way,
thereby transforming the liquidity crisis into solvency problems of
individual banks. The governments, then, are forced to step in and to
recapitalise the bank only to find out later that when the liquidity crisis
strikes again, the capital has evaporated. The governments throw fresh
capital into a black hole, where it disappears quickly.

Central bank liquidity provision, although necessary, has also failed to
address the co-ordination failure and has only made it easier for banks to
dispose of long assets to acquire short ones (cash). Thus central banks’
liquidity provisions do not stop the massive destruction of credit and
liquidity that is going on in the economy.

The recent decision of the US Federal Reserve to bypass the banking system
and to lend directly to the non-banking sector by buying commercial paper is
a step in the right direction. It allows companies to obtain cash by
borrowing long; a service banks do not want to provide anymore. The step
taken by the Fed is insufficient, however. The Fed cannot take over all bank
lending operations. Only the government can do this by temporarily
transforming private banks into public ones. It can then order the
management of these state banks to lend to each other.

Such a transformation (call it a temporary nationalisation) will make it
possible to jump start the interbank market and allow the normal flow of
credit to be activated. Nationalising the banking system is not the only
intervention necessary. There is today a general distrust of private debt.
This will force the government to substitute private debt for public debt.
The Paulson plan does just that. More Paulson plans will be necessary to put
a floor on the price of private debt and to prevent a meltdown.

The temporary nationalisation of the banking system and the substitution of
private debt by public debt will allow us to reach a new equilibrium. When
this happens, a fundamental reform of the banking system will be necessary
in order to remain in this benign equilibrium. When this is achieved the
governments will be able to privatise the banking system again.

The writer is professor of economics at the university of Leuven and Centre
for European Policy Studies

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