Wednesday, May 9, 2012

Do insolvent banks need positive book equity levels to make loans?

The primary reason given for governments bailing out banks is 'the banks need the capital if they are going to continue to make loans and support the real economy'.

So the logical question to ask is 'do banks need capital to make a loan?'

The answer to that question is NO!

How a loan is funded, and capital is a source of funding, is and always has been separate from the issue of whether a bank is going to make a loan or not.

This separation between funding and lending makes sense because there are many alternative ways to fund the loan.  For example, it can be retained on the bank's balance sheet, sold to another bank in whole or part, or sold in its entirety to a third party like a hedge fund, pension fund or insurance company.

The corollary to the question of do banks need capital to make a loan is 'do insolvent banks need positive book equity levels to make a loan?'

Again, the answer is NO!

Capital is still a source of funding.  A bank with negative book equity would not be able to use capital as a source of funding and would have to rely on alternative means to fund the loan.

The US Savings & Loan crisis in the late 1980s provides the best example of the simple fact that banks will keep lending regardless of their solvency and capital levels.  It was recognized by management of the insolvent and frequently capital-less S&Ls that continuing to lend was its best strategy for digging the S&Ls out of the hole they were in.  They lent so much money they funded a commercial real estate bubble.

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