I added ‘of insolvency’ in parenthesis to the title of an article that appeared today on Bloomberg.com to stress a central point that the article failed to emphasize. Solvency means having enough assets to meet liabilities in the long run. To ensure solvency, the enterprise needs to correctly price the production value of its assets and also have an adequate cushion for losses suffered on unproductive assets. The former has been expedited by the mark-to-market account rule, which has also stripped banks of the flexibility to gradually absorb their losses on the asset side. This rapid decline in asset value is what prompted central authorities to inject capital and shield banks from insolvency.
While government ownership is unquestionably a viable solution in the short run, there must be an exit strategy to prevent the government from exerting greater management control in the long run. Private money may be too shy to invest in common shares without government guarantees, so the banks have to rely on their earning power to build up equity. In order to earn their way up, banks are justifiably propping up the spread by maintaining a high lending rate.
It’s easy to see how banks would maintain high lending rates until private capital is confident enough to jump back into the fray.