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The critical issue is whether main street businesses that rely on credit to fund their operations will be cut off, suddenly, from credit. A sudden cut-off of credit to otherwise healthy companies would trigger a severe recession, but I think we have the tools in place now to prevent that.

Bank credit depends on two key issues: do the banks have the raw materials for loans, and do the banks have the capital necessary to make loans.

If depositors remove money from banks, there's a raw material problem.  However, the Federal Reserve has the authority to lend to banks as needed to maintain credit flows. They also have the authority to extend their credit outside of traditional commercial banking. I am convinced that the Fed will make the raw material available to banks as needed.

The second issue is capital capacity. Bank shareholders have to have some skin in the game. If the value of the bank's assets falls, then the capital of the bank falls. At some point, capital might become insufficient for the size of the bank. The bank then must either sell more stock, or shrink its assets, such as by refusing to make new loans.

What's the condition of banks? As of the end of last quarter, commercial banks and thrifts had core (Tier 1) capital equal to 7.89% of their assets. Is this a lot?  It's down from a year prior, but here's the requirement: to be "well capitalized", a bank needs six percent. So the industry as a whole was well above standards. The FDIC Quarterly Banking Profile reports that over 99% of the assets of banks and thrifts were in well capitalized banks. Banks that are under six percent but over four percent are called "adequately capitalized," but despite the title operate under some restrictions. With less than four percent capital banks need a plan to pull themselves up to adequate capitalization.

We don't know how the summer's market turmoil is hitting banks. We'll certainly have a number of banks drop in capital when the Sept. 30 report is published.  However, I think we'll still have adequate capitalization overall.

Here's what bank regulators need to do. Cut some slack on institutions that have low capital because of mark-to-market requirements in thin markets. Encourage poorly-capitalized banks to participate loans out to well-capitalized banks. (This means Bank A lends a company $100, then passes a portion of the IOU over to Bank B.)

With aggressive Fed lending to banks that have lost deposits, along with reasonable judgment by regulators, credit can continue flowing to healthy banks and consumers. That means the real side of the economy, spending, production and income, do not go into a worse downturn.

Source: What Bank Regulators Need to Do to Avoid a Recession