What About Bank Capital?

The Obama team’s plans are big and bold on key dimensions.  The fiscal stimulus will be one of the largest ever in peacetime.  We don’t yet know how much support there will be for a housing refinance initiative, but there is no question that the proposal will be huge.

But in this mix the lack of serious discussion (yet) of the need for new capital in the banking system is striking.  It could be, of course, that reports on the lack of capital have been greatly exaggerated.  And it could also be that a detailed assessment of the capital injections so far might indicate they have had less effect than previously expected – although you have to think about the counterfactual, what would the situation be now without these capital injections?

Most likely, the strategic thinking is along three possible lines here.

1) No more capital is needed because the fiscal stimulus will be large enough to turnaround the economy, bringing back growth and gradually steepening the yield curve (so banks can go back to making money the good old-fashioned way; borrow short, lend longer).  This is a plausible approach, but  risky.  There is a great deal that can go wrong or at least delay the positive effects of a big fiscal push, particularly in the current global economic environment – see my piece on Forbes.com today.

2) If more capital is needed at any point, it can be provided on the same sort of terms that Citigroup received in November.  This seems dubious because I would expect a political backlash if there is an attempt to repeat or scale up this deal.  The terms were simply too unfavorable to the taxpayer.  And we should probably now move beyond relying on weekend rescues of major financial institutions; too much can go wrong under that kind of pressure.

3) If more capital is needed, there is a plan but it is secret for now.  This might have some appeal, in the sense that any plan would be controversial and could distort incentives.  But Congress would surely appreciate knowing at least the potential scale and strategic direction for bank recapitalization in advance – after all, Mr. Paulson’s surprise request to them in September did not go down well initially and did not work out well later.  Any sensible plan would presumably involve the commitment of some hundreds of billions of dollars.  This would be an investment on which the government can earn a good return, but more details in advance on potential deal structures could help us understand exactly the value proposition for the taxpayer.

Some proposals – after we saw what happened at Citigroup – for recapitalizing the banking system are here.  Our approach may not be the answer, and I understand why many on Wall Street would prefer to do things differently.  But I do think we need more debate around a plan for recapitalization contingencies, and this should be done sooner rather than later.