Central banks have been impaled on the horns of a dilemma since last August: How can they save the financial system without bailing out foolish banks? Here’s a way. Tell the banks it is quid pro quo time. In return for accessing central bank liquidity, they should be required to raise capital—lots of it.
The US Federal Reserve Board, the European Central Bank, et al, have sprayed more and more money into the financial system in a desperate attempt to avoid a crisis turning into a cataclysm. And the banks, in turn, have raised capital: UBS AG and Lehman Brothers Holdings Inc. are the latest.
Henry Paulson, the US treasury secretary, has become increasingly vocal about the need for banks to strengthen their balance sheets. And Fannie Mae and Freddie Mac, the US state-sponsored mortgage groups, have had to agree to raise extra capital in return for being allowed to hoover up more mortgages in the market.
But the financial system remains in intensive care. It is only able to operate even half-normally because of the liquidity injections. The more capital banks have, the less they will need to lean on the taxpayer. Banks will need to be a lot better capitalized in order to avoid a repeat of the problem.
Bank bosses do not like to raise lots of capital. It’s dilutive and, as UBS’ Marcel Ospel has just found, can cost you your job. But the central banks now have the perfect opportunity to force the bankers’ hand. This is the speech they should make: “You want access to our cash? Well, come up with a credible capital raising plan. The more liquidity you want—and the dodgier the assets you want to give us in return as collateral—the more capital you have to raise. If you don’t, we’ll hang you out to dry like Bear Stearns.”
Behind the scenes, it is possible the authorities are making such speeches. If not, they are missing a golden opportunity.