Wednesday, October 15, 2008

Why can’t the private market solve the credit crisis? Why should the taxpayers have to pay for the mistakes that the banks made?

One reason the private market will not inject equity now is out of the same concern that makes banks reluctant to lend to each other: fears that some banks have undisclosed bad assets (which are hard to value because they are not trading now) and may become insolvent.

This makes investors fear that they may choose a bank that will soon fail. Moreover, if investors fear that many banks will soon fail, there will be runs on many others. These runs would wipe out the value of the private-equity injection. During a crisis, it is safe to provide capital to a given bank only if all banks become well capitalized (either by raising new capital or being acquired by well-capitalized banks). This makes outside investors hesitate to provide new equity.

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