Lessons from the Global Financial Crisis (Or Why Capital Structure Is Too Important to Be Left to Regulation)

Brian Kantor and Christopher Holdsworth

Journal of Applied Corporate Finance, 2010, vol. 22, issue 3, 112-122

Abstract: Given the likelihood of periodic financial crises, much of the focus of policymakers should be on the proper response to rather than the prevention of crises. In this article, the authors begin by repeating Walter Bagehot's famous prescription for resolving financial trouble in the 19thcentury London money market: flood the system with liquidity and do all that can be done to keep the capital markets open and functioning. Although this message was disastrously ignored by the Federal Reserve Bank of 1929–33, Bagehot's advice was well understood by the Fed and U.S. Treasury in managing the crisis of 2008. For regulators and bank executives alike, the capital of consequence that stands between financial institutions and their ruin is not the capital on their books, but the market value of their equity capital. The ability to raise capital from the marketplace—if need be, from its own shareholders—may well prove the essential factor in a company's ability to weather a crisis. Using a variation of Robert Merton's option pricing model, the authors show how and why the share price volatility associated with a financial crisis threatens solvency and how companies can measure their rising default risks and act in good times to raise fresh capital to cope with depleted balance sheets. Regulations designed to prevent future crises should not be allowed to threaten the profitability of financial activity to the point where raising fresh capital from private markets no longer makes economic sense.

Date: 2010
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