The banking crisis arose because banks became too leveraged. Their assets (mortgages etc.) were funded by too much borrowing (deposits, bonds, interbank loans etc.) and too little shareholder equity.
When it became clear that bank assets were not worth what was thought, creditors asked banks to repay some of their over-borrowing. Banks can't sell their assets quickly at anywhere near to their book value and they don't have enough equity to carry on covering creditors who refuse to renew loans.
Therefore banks will fail unless they recapitalise, i.e. increase their equity relative to their borrowing
They tried to do that through rights issues but now the replacement equity is worth less then shareholders paid in for it only months ago. Few shareholders want to throw good money after bad when they are not sure that the equity will be worth anything.
Unless someone else is made to buy new equity then banks will go bust. We are being told that there is no alternative to the taxpayer buying that new equity. But there is - the creditors. It is the creditors (excluding depositors with <£50,000 who are insured) who lent the banks money who stand to lose most in a lengthy liquidation if banks go bust and armies of lawyers and accountants are left to pore over the mess. It is therefore those creditors who should recapitalise the banks. They should do that by swapping a small proportion of what they lent to a troubled bank for new equity in that bank. The Bank of England should determine how much debt has to be swapped and at what price in order to restore solvency. This would have to be done quickly, if necessary by using emergency legislation and keeping markets closed until exchange terms are announced. Inevitably, not everyone would agree that the terms chosen were fair, but this may now be the least bad alternative open to us.
Existing shareholders would be diluted but their bank would be solvent. If confidence recovered both the shareholders and the creditors could benefit - the prospect that the government is optimistically holding out for taxpayers now. However, a debt for equity swap, or a Bank of England supervised reconstruction as we described our equivalent policy for Northern Rock, is more likely to work because - unlike a taxpayer bailout - it reduces banks' over-borrowing at the same time as it increases banks' equity. Moreover, if it doesn't work as well as hoped, it would be the creditors who invested their wealth in the banks - and chose to keep it there as the banks took greater and greater risks - who would have to absorb the loss. The way to protect the economy, while mitigating moral hazard, is not for government to prop up failing banks, then arbitrarily push one into liquidation, and then change its mind and semi-nationalise all the rest with an open-ended taxpayer commitment. Instead, the Bank of England should step in and swap debt for equity as necessary to restore bank solvency. This would be an extraordinary interference in decisions investors freely made as to how to finance banks. But they got the decision wrong and put in too much debt and too little equity. Government should not make taxpayers pay for the mistake it allowed investors to make. Instead it should require the investors to correct it.
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