The mystery that is: Re-Capitalisation and the Economic Crisis

What exactly is capital? Well in this case it's the outstanding mortgages (the money it has lent and expects to get back) plus the value of the business itself, all minus the debts it owes (including to savers).

For example - bank "Safe & Secure" has lent out £1000 (plus the interest it expects back as well), and is worth £100. It has borrowed (and people have saved) £900. Therefore, the amount of capital is 1000 + 100 - 900 = £200. 

If people default on their loans to "S&S" by £100, then it has enough capital to prevent it going bust and replace that amount until it can lend more. If fewer people save, then it has enough capital to stop it going bust and replace that amount temporarily. Capital in this sense is a bit like a cushion to stop going bust. The more capital, the more secure the banks.

This is why re-capitalisation of banks was needed. 

What happened was that some banks suddenly realised that loads and loads of the mortgages they had lent out (or mortgages that other banks had sold to them as their responsibility) were not secure (AAA rated) mortgages, but that some X, Y or even Z mortgages (e.g. the household will probably never pay it back to the bank - so default on their mortgage) had been mixed in with the AAA ones so that they looked like AAA ones. So the banks realised that lots of their mortgage receivables (the amount they are owed) was a lot, lot less than they'd thought. 

They then discovered that they probably didn't have enough capital "cushion" to replace this, especially as they were also uncertain about which ones were safe and which ones weren't. This panic and uncertainty then made it even worse when savers in some banks thought the bank was going down and decided to remove all their money from the banks before it went bust. 

This then meant that the banks were having the debts they owed recalled immediately. Obviously, they didn't have enough capital "cushion" to replace this as well! So re-capitalising the banks saved them. Whether or not government should have just given the banks the money using that particular method of capitalising is a different matter...
So, what about now?If re-capitalisation stopped the going  bust, why is the rest of the economy now suffering?

Well after they received just enough to keep them afloat, a number of things happened: first of all, many countries increased regulation on banks - the regulators said that the banks had to keep more of their capital "cushion" from now on so that this didn't happen again.Sounds sensible? WRONG!

The banks followed these orders but also started doing other sensible things (from their point of view anyway). First of all, they decided that they wanted an even bigger capital cushion just in case - obviously they were still unsure of how much of their mortgage receivables were still safe - which ones are truly AAA, and which ones are rotten? They also realised that they'd need enough of this to repay some of their creditors, as well as (after re-capitalisation) the government.

So they decided they'd lend less, and start recalling some loans that they thought might be definite defaulters. They also decided they'd lend at higher interest rates, so getting more back from the amount they've lent out, and lower interest rates for people who'd saved at them - so that they'd be able to pay out less to savers/ their creditors. 

More crucially, they also decided that they'd lend less and at higher interest rates to other banks - they didn't know if they had rotten assets either - they'd lose that money completely if the bank they'd lent to went down! This inter-bank rate is called the LIBOR - it became a real indicator of how confident the banks were in each other, and thus started to determine the interest rates for rest of the economy.

The Bank of England tried to decrease nominal interest rates drastically, but obviously most banks refused to pass it on to the rest of the economy. Some said they did - but by not as much as they were "meant" to.

So, with less investment and less lending from banks, the rest of the economy started to go bust. Looking to the future, businesses decided that they needed to cut costs to survive - so they made some workers redundant. Others just went bust, making more workers unemployed. Other households started to fear for their jobs, so they started spending less, so businesses started making less profit, so needed to cut costs further. 

A vicious cycle began. Banks then also decided that if businesses were going bust and people were becoming unemployed, that more lending would be risky and unlikely to be repaid - so they started lending even less, and at higher interest rates...