Let's distinguish between three forms of crisis that firms - in any industry - can face:
- Liquidity crises
- Solvency crises arising from past losses
- Future profitability crises
A liquidity crisis is a lack of available cash to pay bills that are now (or will shortly become) due for payment. If there is no solvency problem, either from past or future losses - in other words, if a firm has assets securely greater than its liabilities and likely to remain greater than liabilities if the firm continues trading - then a liquidity crisis can be resolved straightforwardly by borrowing money.
A solvency crisis arising from past losses is less easy to resolve by just borrowing money - though that may be a solution. When a firm has assets less than its liabilities, there is a risk to its continuing trading, because perfectly normal business practices - like paying bills at the end of the month - will impose risks on the firm's suppliers (if it were to cease trading there would not be sufficient money to pay all those to whom the firm owes money). If a firm's future profitability is secure, it might trade its way out of problems - future profits will restore solvency eventually. In some industries, however, the risks imposed by an insolvent firms continuing to trade will be high (for example, an insolvent firm may be tempted to take great risks, because limited liability for shareholders makes those risks a one-way bet for an insolvent firm). Indeed, in some industries it is considered sufficiently risky for insolvent firms to continue trading that it is not normally permitted - banking would be an example. An alternative way through would be an injection of new capital - "recapitalisation". This restores solvency, and if future profitability is secure, then this may be sufficient.
Lastly, we have a future profitability crisis. By this I mean a situation in which either there will be future losses rather than profits, or, at best, future profits will be insufficient to pay off future interest on current debts. In other words, the company is no longer viable over the medium term in its current form. In such a situation, unless the company is liquidated quickly or action is taken to raise future profitability expectations, equity capital will disappear and the company will become insolvent. In this kind of situation neither lending nor recapitalisation will be adequate, unless accompanied by a credible plan to restore profitability. An attempt to address such a situation by recapitalising will simply throw good money after bad, because future losses will, over time, eliminate the new capital injection - all recapitalisation will achieve is to (a) lose more money; and (b) put off, a little, the day at which the company becomes terminally insolvent.
Initially, many people thought that the current financial crisis was just a liquidity crisis, and so could be addressed by lending - perhaps involving clever lending tricks like the Bank of England's Special Liquidity Scheme.
Later, people thought that it was a solvency crisis associated with past losses, and proposed recapitalising the banks.
I believe that, in fact, for the UK financial services sector as a whole, we face a future profitability crisis. The sector must shrink, so that the remaining players can be restored to adequate profitability. With fewer, more profitable players, the equity value of the remaining players will increase and their capital will prove adequate. The attempt to recapitalise the UK's banks is an exercise in denial - it is an attempt to convince us that the sector can carry on, much the size that it was before, without radical shrinkage. Of course, it might be politically painful to accept that one of our most glamourous sectors is destined to decline - far easier to spend tens of billions putting back the evil day, hopefully until political times are more favourable. But if I am right, this denial will ultimately prove futile, and good money will have been thrown after bad.
