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The financial crisis is turning out to be a tough learning process for economic policymakers in the West, who find that they are trying to nail a target that is continually changing. The failure of Hank Paulson’s US Congress-approved Tarp to calm the markets and shore up confidence is forcing policymakers to think further. The latest ‘consensus’ doing the rounds is the need to urgently recapitalise banks, who are no more simply battling illiquidity—the problem Tarp was addressing by offering to buy out troubled mortgage-related assets—but are instead battling insolvency. Bank assets are simply not enough to cover liabilities. This not only furthers mistrust between banks and dries up money markets more, it also adds the more serious dimension of depositor distrust which can culminate in a run on the banking system—hence the sudden en masse bank deposit guarantees being doled out by numerous governments in Europe. Hank Paulson had hoped that banks might be able to raise capital themselves once the federal government cleared their toxic assets, thus improving the overall quality of assets. However, it doesn’t seem that this is likely to happen. Capital isn’t forthcoming. Having seen even the mighty SWFs burn their hands by buying into banks earlier than they should have, most investors are erring on the side of caution.
Under the circumstances, the UKs rescue plan which Hank Paulson has hinted he may also follow, is a constructive alternative. The plan, in addition to buying out toxic assets, also has a provision for the government to buy equity stakes in banks in an effort to recapitalise the financial system. It admittedly means the largest scale nationalisation of the financial system in the West at any point in the near future—but the priority at the moment is to get credit flowing into economies of the US, UK and indeed the global economy. A supplementary possibility, which would reduce the role of government as an equity holder, is for the government to arrange a massive debt-for-equity swap where creditors are forced to accept equity in exchange for a bank’s debt at reasonable terms. That would improve the asset-liability ratio instantly and make banks solvent without even government equity. However, give the depth of the crisis it is unlikely that the government can persuade hesitant creditors to accept this unless the government too joins them in an equity injection. Tarp has a provision for this. So does the...
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