The "Bank Plan" Can Work

The idea of ring-fencing assets that banks fear might decrease further in value is central to any solution that would compel banks to increase bank credit. With fears about further losses reduced, banks would deploy the massive amount of cash they currently hold (U.S. commercial banks currently hold 10%, or $1.1 trillion of assets, in cash, up from the usual $300 billion), as well as from their securities holdings, where banks are earning less than they could be earned from the net interest margins on new loans.

It looks likely that the Treasury and the Fed will adopt a blended approach, a menu of solutions meant to fit the variety of problems that banks have. One possibility is for the Treasury to inject cash into the Fed as seed money for a special-purpose vehicle that purchases or ring-fences the assets that banks hold. This would be constructed in a way similar to the Fed's Term Asset-Backed Securities Loan Facility (TALF), the $200 billion facility that leverages $20 billion of money from the Treasury to buffer the Fed against losses. Such a design could see the Treasury inject, say, $100 billion that the Fed leverages up to $1 trillion.

Central to any stabilization plan will be the cordoning-off of bad assets. This is necessary to unleash the mountain of cash I mentioned. The excess reserves and their potential for creating new credit (by a factor of 10 to 1) is a major source of optimism regarding the cordoning-off idea.

An added boost that will help revive bank credit will be legislation that encourages homebuying (the $15,000 tax credit for all home buyers) and TARP-related efforts to both boost homebuying through low-interest loans and stem the slide in mortgage foreclosures. Reductions in home inventories will have a major impact on home prices and therefore on financial assets and the real economy.