This would be entirely appropriate in current circumstances. Encouraging relatively weak banks to expand their portfolios is a risk not worth taking at this time of global financial crisis, notwithstanding the need to stimulate private spending.

Already one small bank has failed, so the authorities also need to be prepared if they should be confronted with a bank run. One alternative to the mooted blanket guarantee of bank liabilities would be immediately to freeze the operations of any bank facing large-scale withdrawals, and to appoint an independent temporary management team. This team would undertake a quick, conservative estimate of the value of the bank’s assets, and if this was less than its liabilities the shareholders would be required to inject new equity without delay.

Failure to do so would result in the issue of new shares to depositors and other creditors in return for a debt ‘haircut’—a write-down of the value of their exposure to the bank—sufficiently large to restore capital to an acceptable level. This would allow banks’ solvency to be restored immediately, thus removing the cause of the run. Accumulated losses up to that time would be borne by bank shareholders and creditors rather than ‘innocent bystanders’—the general public—as would be the case with a government guarantee.

This post is a digest of the APEC Economies Newsletter for March 2009, which may be found here [.pdf].

Ross McLeod is Associate Professor, Research School of Pacific and Asian Studies, ANU and Editor of the Bulletin of Indonesian Economic Studies.