Financial Crisis: The Two Sides of the Balance Sheet

Noam Scheiber at The New Republic has the inside scoop (hat tip Ezra Klein) on why Treasury is letting the Public-Private Investment Program die a quiet death (although at this point the legacy securities component may still go ahead). In short, the argument is that the point of PPIP was to help banks raise capital by cleaning up their balance sheets; since they have been able to raise capital themselves, there is no need for PPIP. According to one person Scheiber spoke to: “If you had asked–I don’t want to speak for the secretary–what’s problem number one? I think he’d say capital. Problem two? Capital. Problem three? Capital.”

This represents the latest swing of the pendulum between the two sides of the balance sheet. As anyone still reading about the financial crisis is probably aware, a balance sheet has two sides. On the left there are assets; on the right there are liabilities and equity; equity = assets minus liabilities. (There are different definitions of capital, depending on what subset of equity you use.)

The goal has always been to provide confidence that there is enough capital to withstand the impact of market and economic turmoil – in particular, its impact on the toxic assets that litter banks’ balance sheets. However, there are two alternative approaches to doing this. One is to add more equity to the right side by issuing new stock (preferred or common). (This would add cash to the left side to keep them in balance.) The other is to reduce the uncertainty of the left (asset) side by helping banks sell toxic assets; even if the banks have to sell them for a little less cash than their current balance sheet value, this would have the salutary effect of reducing vulnerability, since cash does not lose value (at least not in an accounting sense). Alternatively, you could achieve the same effect by insuring the value of the assets while leaving them on bank balance sheets, because then the risk transfers to the insurer.

The initial Paulson Plan last September focused on the left side; the idea was to buy toxic assets off of bank balance sheets. Then in October Treasury did an about-face and switched to the right side, recapitalizing banks by buying preferred stock from them (TARP). In November and January, Treasury and the Fed did combined bailouts of Citigroup and Bank of America, in which they both provided fresh capital and guaranteed certain assets against falls in value. In February and March, Treasury shifted all the way over to the left (asset) side with the PPIP, which was hailed (by its supporters, at least) as a way to cleanse bank balance sheets – something that had not been accomplished by TARP. Now, it seems, we are back to the right side; as long as banks can raise more capital, everything is fine, no matter how many toxic assets they may hold.

One key to the financial crisis has been nervousness about toxic assets on bank balance sheets. It’s nice that people aren’t so nervous anymore. But as Raghuram Rajan said to Klein, “if we reenter the downturn, and the banks begin to look shakier – we’ll wish we had moved the assets when the market was calm and stable, rather than leaving them to create uncertainty and volatility at the center of the banking system.”

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About James Kwak 133 Articles

James Kwak is a former McKinsey consultant, a co-founder of Guidewire Software, and currently a student at the Yale Law School. He is a co-founder of The Baseline Scenario.

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