Here's a neat plan by Ricardo Caballero to recapitalize banks without direct public expenditure: guarantee share prices for future dates.

Here is a “simple” proposal: The government pledges to buy up to twice the number of shares currently available, at twice some recent average price, five years from now. (Obviously the specific numbers are only an example.)

While the policy is about future (and unlikely) interventions, the immediate impact would be enormous. In particular, it would turn around the negative stock markets dynamics, and it would allow banks to raise private capital.

The most direct effect would be an increase in the price of banks’ shares by much more than 100 percent, as the pledge puts a floor on the price five years from now, but the upside potential is huge once we get over the crisis hurdle. That is, buying equity from these banks would become like buying Treasury bonds plus a call option on the upside. By the strong forces of contagion, this rise would immediately spread to non-financial shares. Consumers, especially retirees, would see some of their wealth replenished; insurance companies would see their balance sheets improve; destabilizing short-sellers and predators would be wiped out (a la Hong Kong in 1997); and we would have the foundations for a virtuous cycle.

Amplifying effects and taxpayer costs

The second and reinforcing effect would be the stabilization of the financial sector, as banks would now possess the conditions necessary to raise private capital. Until now, banks have not wanted to raise capital because this would be highly dilutive at the current prices. Potential investors have no interest in injecting capital either because there is an enormous fear of further dilutions, especially through public interventions and, worse yet, outright nationalizations. A pledge to support the shares in the future, instead of the threat of nationalization in the short run, would reverse these bad dynamics and quickly recapitalize the banking sector.

How much will this cost the taxpayers? Most likely nothing. It is highly unlikely that the crisis will last five years, especially in the presence of an aggressive policy response, and most banks’ shares are likely to trade for many times current prices. In fact, I wrote “twice the recent prices” in my proposal to reduce the shock effect, but it may well be better to go for four times (and perhaps lengthen the period to ten years).

Best plan I've heard so far.

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