John Hempton has a must-read post in which he says that determining bank solvency is difficult. I think he understates the difficulty, because he does not get into the issue of valuing short put options that once were way out of the money and now are close to being in the money (if that language confuses you, think of trying to value a property insurance company with a lot of policies written in Gulf states when a huge hurricane threatens. Maybe the insurance company will be solvent after the hurricane makes landfall–and maybe it won’t). Hempton suggests moderate forbearance.

My view – and it is open to debate – is that a reasonable sort of regulatory buffer is that a bank – properly provisioned when the disaster happens – should be forced to have about a third required regulatory capital – and should be restricted from reducing that capital (dividends, buybacks etc) until the buffers are fully restored. Forbearance is right at this point of the cycle – unlimited forbearance is not.

Since this has been my position since September, I am sympathetic to this view now. I want to see triage. A healthy bank, that meets required regulatory capital standards, gets as much freedom as it has always had. A bank that has negative capital gets put through a rapid-bankruptcy or FDIC receivership process. A bank with positive but inadequate capital gets put under close supervision to make sure that it does nothing to detract from or risk from its capital adequacy.