How will a capitalization plan actually work?

I’m all for bank capitalization but the problem is this: the Fed has been lending hundreds of billions to banks for many moons.  Right now the banks are just sitting on the money, for the most part. 

To be sure, Treasury equity is not the same as debt to the Fed, but are they so different?  Keep in mind the Fed has been a softie to A.I.G. ($30 billion more), so the Fed is hardly a loan shark and in some ways the Fed’s I-can’t-just-stop-rolling-it-over-when-I-want contribution is a bit like preferred equity.

To put it another way, will partial government ownership so much change bank incentives for the better?

Which is it?

1. Treasury capitalization will matter to the extent that Treasury equity has some different properties than from-the-Fed debt, but this isn’t nearly as much of an effect as any published sum for a Treasury capital inflow would indicate.

2. Treasury equity will work because of some legal or regulatory difference between equity and debt which we are otherwise unwilling to abolish.

3. Treasury equity will work because it is a hidden giveaway to bad banks (by the way, this is arguably what happened in Sweden).  But of course we could do the giveaway more directly if not for bad PR.

Inquiring minds wish to know.

Three other points:

4. Capitalization might have a bigger marginal oomph in Europe than here, because the ECB hasn’t been going crazy lending out reserves as the Fed has.

5. If the key is to get banks up and running again, we want bank CEO contracts with lots of bonus compensation on the profit upside and those contracts are more important the "worse" is the bank.  Ouch.

6. If such a plan will raise the value of lots of banks, by a lot, none of the shareholders will wish to sell early at low prices, a’la Grossman and Hart 1980, and the Treasury will be back in a bind.

That is what Alex and I talked about over dinner.  I conclude that the crisis will not end anytime soon.

Comments

Everyone keeps talking about re-capitalizing banks but can someone take the time to explain what that actually entails? When a bank is building up capital, what exactly are the nuts and bolts of what they are doing? I looked up what capital was but can someone explain how a bank would go about raising their "wealth, whether in money or property, owned or employed in business by an individual, firm, corporation, etcetera.?"

"....so the Fed is hardly a loan shark"
read the terms of the AIG oan
set up fee 2%
fee on UNdrawn balance: 850 bp
fee on drawn balance: libor+850

BANK. Get it?

As a layperson, it seems there are two different problems.

1) Ensuring that bank depositors get their money back. This is accomplished by FDIC insurance, and perhaps other limited measures.

2) Getting the banks lending again. Giving banks money (whether through equity, debt, or simply giving it away) does not automatically create lending. The quesion is who will the banks lend TO: GM, individuals at risk of losing their jobs, small businesses in an economy spiraling downwards? You can be sure that the banks arent willing to bet on promises as before, they will want proof of an ability to pay, either through profits/income or from assets (ie equity or reserves.) With so many of us (individuals and business alike) either loaded up on debt, or reliant on credit to survive, few will be able to meet these requirements. So the money will just sit there in the bank vault (or T bills), and we will have spent billions with no impact.

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