V. Public Capital Injections into Insolvent Financial Institutions

This part focuses on public capital injections into banks, which for short we will call “bailouts,” as distinct from liquidity support from the Federal Reserve or deposit or short-term liability insurance. While the central bank’s role as lender of last resort is well established, bailouts are more controversial. As Bernardo, Talley, and Welch (2011) suggest, prior to 2007 most academic economists viewed government bailouts as “aberrations of developing countries, artifacts of political patronage, or idiosyncrasies of the banking industry.”1 Significant academic skepticism remains “about the wisdom of bailouts as a categorical matter.”2 However, as with TARP, bailouts are realistically the lesser of two evils, if economic collapse is the alternative.

While central bank liquidity and guarantees should be the first line of defense against contagion, one may still need to deal with the negative economic impact of the failure of large banks. Such multiple failures can arise due to correlation risk, the same negative external event, such as a sharp decline in housing prices. The first line of defense against insolvency is capital or increased TLAC to allow resolution, but even higher capital requirements or TLAC may be insufficient to protect the system against widespread, steep losses. While one can possibly envision resolving one or maybe even two of our largest financial institutions simultaneously in OLA, an entire insolvent system is another matter. Indeed, this is what Japan faced in the “lost decade.”

Capital injections may become necessary when other measures, including central bank lending or government guarantees are no longer effective. If a large number of financial institutions are in trouble because significant losses have consumed their equity base, additional lending to the institutions may not help. To remain viable, the institutions may have to be recapitalized. As one commentator put it, no matter how much a central bank lends to entities with negative capital, “the capital is still negative.”3

Bailouts through use of public funds are only necessary when efforts to raise private capital do not succeed. Private capital, however, may be insufficient and may therefore make public investments necessary. Due to asymmetric information, private investors may refuse to invest in troubled financial institutions; the government may be in a better position to overcome the information asymmetry.4 In addition troubled financial institutions may not be able to attract new private equity because of the problem of “debt overhang.” If a firm is heavily leveraged and is on the verge of bankruptcy, any increase in firm value due to an equity infusion largely goes to debt holders.5 Government intervention thus becomes necessary to overcome the debt overhang problem.

In theory, troubled financial institutions could sell their illiquid and troubled assets to generate capital. Diamond and Rajan (2010) ask why new investors, such as vulture funds, did not step in to purchase those assets at a bargain price during the financial crisis.6 They argue that the possibility of a future fire sale may explain banks’ inability to dispose of toxic assets. Greenwood et al. contend that modest equity injections can dramatically reduce systemic risk if they are optimized to minimize the aggregate impact of fire sales.7 Yet a recapitalization plan could be quickly rolled out and would have the added benefit of boosting lending activities.