This desire to postpone capital raising stems, in part, to the fact that bank executives often do not want to dilute the existing shareholders (which, of course, include themselves). I believe that the management calculus has often gone like this: In good states of the world, I have enough capital. In bad states of the world, perhaps I don’t. But to raise enough capital to guarantee I can endure all the potential bad states of the world, I will have to massively dilute my existing shareholders now. So the self-interested thing to do is to avoid the dilution and hope for a good state of the world. This does not always work well in practice. Once capital preservation becomes paramount, deleveraging intensifies and counterparties grow more wary about engaging. This dynamic, in turn, makes a bad state of the world more likely. What may be sensible for each institution individually, may collectively be a bad idea. That is because each firm does not internalize the cost that their decision not to raise capital has on the overall financial system. A healthy banking system is always essential. But never has that been more true right now given what has happened to the securitization markets and the broad “shadow” banking system. So where are we now? In my view, the deleveraging process is still far from complete. Hedge fund redemptions have soared.
It would not be surprising that when we’re done, hedge fund assets (before leverage) will have fallen in half or more from their peak of about $ trillion. Of course, the Madoff scandal and other episodes of misappropriated funds have further undermined confidence, reinforcing the redemption pressure. Most importantly, the pressure on the financial system has been exacerbated by the deterioration in the economic outlook following the Lehman failure. Before last fall, the causality ran mostly from the turmoil in the financial system to the real economy. Since then, the real economy has contracted sharply and this has reinforced the balance sheet pressure on banks and the forced deleveraging process. So where do we go from here? Well fortunately, it is not all bad news – there are a number of programs that have been enacted that have already made a difference. And several new initiatives are being enacted now that should help to support and bolster the financial system. Those areas where the Federal Reserve and the Federal government have responded in force are doing somewhat better. Banks and dealers have plenty of access to liquidity. The Term Auction Facility or TAF – in which funds are auctioned off to banks – and the Term Securities Lending Facility or TSLF – in which auctions are held to borrow Treasuries from the Federal Reserve – have recently been undersubscribed, indicating that the facilities have been sufficiently sized to meet the demand for liquidity.