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Economic SYNOPSES
short essays and reports on the economic issues of the day
2008 ■ Number 29

The Great Recapitalization
Edward Nelson
n October 14, 2008, the U.S. Treasury announced
a voluntary Capital Purchase Program intended to
increase the flow of financing to U.S. businesses
and consumers. Under the program, the Treasury will inject
capital directly into the banking system by purchasing senior
preferred equity shares from certain depository financial
institutions. Historical precedents exist for these measures,
including the bolstering of bank capital with U.S. government funds by the Reconstruction Finance Corporation in
the 1930s and the recapitalization of banks by governments
in the Nordic countries in the 1990s. This new Treasury
recapitalization program is simply the latest policy action
of its kind, implemented to respond to recent changes in
market perceptions of the risks facing the U.S. banking
sector.
During the past several decades, U.S. commercial banks
have diversified, continually moving away from their traditional deposit-taking and lending business into lending
that is not financed by deposits or by other bank liabilities.
Beginning in the 1970s, securitization permitted banks to
originate and sell loans, rather than holding loans on their
balance sheets. Banks developed new instruments—such
as leveraged loans and guarantees on commercial paper—
that allowed participation in commercial lending without
on-balance-sheet intermediation. This trend was accelerated,
to some extent, by the incentive to avoid new regulations
and increased capital requirements. The innovations were
widely regarded as effectively strengthening the banking
system. For example, a 2003 analysis observed that “the
improvements in risk management offered by securitization,
loan syndication, and hedging via derivatives instruments
have helped banks shed unwanted risks.”1
Recent financial turmoil has strained bank balance sheets
and called into question previous opinion on how securitization would affect bank risk. Many highly leveraged loans

O

became unmarketable. Contingent liabilities, such as letters
of credit, became burdensome as banks found themselves
obliged to bring onto their balance sheets these securities
whose market prices were substantially below the original
values. House price declines called into question the value
of mortgage-based derivatives, while the government conservatorship of Fannie Mae and Freddie Mac, as well as
the Lehman Brothers collapse, meant that banks incurred
losses on their investments in these institutions. The deteriorating outlook has led financial institutions to become
more conservative in their loan-making policies and more
prudent overall: Banks are rebuilding their capital at the
same time that equity price declines have damaged their
capital base. One clear result of the retrenchment of banks
and the deterioration of balance sheets is the high spread
on interest rates on interbank loans (which have risen) over
returns on Treasury securities (which have declined).
This contractionary pressure on banks’ balance sheets,
furthermore, comes when considerations about stabilizing
the economy justify the expansion of banks’ portfolios at a
faster rate. The Treasury’s Capital Purchase Program therefore can be seen from a macroeconomic perspective as a
means of arresting the contractionary pressure on the economy. Bank equity capital is a bank liability, as are deposits.
Bank equity capital is being boosted by the official recapitalization program, and the safety of deposits has been reinforced by recent legislated increases in deposit insurance.
These policy measures shore up the liabilities side of the
bank’s balance sheet and, in so doing, encourage expansion
of the asset side. These effects help subdue and reverse
pressure for financial and economic contraction. ■
1

Krainer, John and Lopez, Jose A. “The Current Strength of the U.S. Banking
Sector.” Federal Reserve Bank of San Francisco Economic Letter, Number 2003-37,
December 19, 2003, pp. 1-3; www.frbsf.org/publications/economics/letter/2003/
el2003-37.html.

Views expressed do not necessarily reflect official positions of the Federal Reserve System.

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