It’s long seemed obvious to me that without large injections of fresh capital, all the other efforts to deal with the ever unfolding financial crisis would prove inadequate. Or even counterproductive. The official debate has finally swung in this direction but the question of how best this might be achieved remains a tricky one.
Of all the approaches I’ve seen so far, I’m most taken with that put forward by the Brits. Things may change, since negotiations are still very much underway, but at the core of their proposal is this elegant solution:
The way in which the money will be raised has also been simplified. The government may have to underwrite an issue of ordinary shares. This would give pre-emption rights to existing investors, and those shares not taken up will be owned by the government. These could be placed in a new bank reconstruction fund that would hold them until conditions improve.
Not only are the property rights of current shareholders respected, it sidesteps any need for the existing capital base to be wiped out before new capital can be supplied. This dire prospect was a serious drawback of many other recapitalisation schemes since it pretty much guaranteed that private capital would, in a climate of such extreme uncertainty, simply sit on its hands.
Under this plan, that’s no longer the only rational approach; instead it becomes a matter of deciding whether the proposed capital structure is sufficient to weather the storm. In principle, this is no different to the kind of decision capital always has to make. At the same time, existing shareholders would pay a heavy price through dilution if they chose not to take up their entitlement. Together with the damage already done to the value of their shares, this ensures a decent balance is maintained between risk and reward.
Should a first round of recapitalisation prove inadequate (as seems to me likely given the scale of the underlying problems), precisely the same approach can be used again. And again.
Much can, and probably will, go wrong and I have little doubt exceptionally difficult times lie ahead even with the very best of plans. Still, if something like this does become the new black for financial officialdom, the odds on a truly catastrophic outcome will have lengthened a good deal.