In particular, in many cases the expected share price would be higher without dilution even admitting the possibility of a “bad state of the world” scenario. The problem with this approach was that each individual bank’s decision not to raise capital to protect against the “bad state of the world” scenario increased the likelihood of the “bad state of the world” scenario. There was an important externality. If a bank raises additional capital, it doesn’t just make its own bank stronger, it also makes the entire banking system more stable. Yet it reaps only a portion of these benefits. This was the collective action problem that the SCAP was designed to remedy. Perhaps, I can best illustrate the problem via two figures. In Figure 1, banks have sufficient capital. The mean value of capital is well above zero, the distribution is narrow, and none of the distribution falls below zero – everyone believes the bank is solvent. In Figure 2, losses push the distribution of capital to the left and uncertainty about the value of the assets widens the distribution. Thus, unlike the case in Figure 1, a portion of the distribution falls below zero. The bank may be insolvent. Thus, the bank is likely to encounter funding difficulties. The point of the SCAP was to push the probability distribution back to the right by adding capital – and to narrow it by creating more certainty about how much capital the banks need.
This is especially the case if the collateral is lower quality and markets are already illiquid. Moreover, if creditors are left with the collateral instead of being repaid, fear of widespread collateral liquidation might further erode collateral values. If investors respond by seeking more collateral to ensure they will be secured – that is, that they will be made whole in a liquidation scenario – the firm may run out of high-quality collateral that the firm can borrow against. This is a significant risk when a financial firm is highly leveraged and equity is only a very small proportion of total assets.5 The risks of liquidity crises are also exacerbated by some structural sources of instability in the financial system. Some of these sources are endemic to the nature of the financial intermediation process and banking. Others are more specific to the idiosyncratic features of our particular system. Both types deserve attention because they tend to amplify the pressures that lead to liquidity runs. Turning first to the more inherent sources of instability, there are at least two that are worthy of mention. The first instability stems from the fact that most financial firms engage in maturity transformation – the maturity of their assets is longer than the maturity of their liabilities.