Banks and the Bailout

Some of you have complained that banks are wrong not to have loaned the money they received from the government bailout program [‘TARP’ for short]. There is plenty of angst in Congress over the same issue, so let me explain what I think has been going on.

Only about half of the money set aside has been used so far [$350 billion out of $700 billion], and about 100 banks have received money as part of the TARP program. Originally Congress set aside the money so that the Treasury Department could buy bad assets from banks and thereby enable the banks to concentrate on lending rather than worrying about what to do with bad assets. The banks had already been taking an unprecedented battering to their capital, so the idea was that getting rid of the potentially bad assets would prevent further damage to capital ratios.

Remember that banks lend a multiple of their capital and are required by the various regulatory authorities to keep plenty of capital to absorb losses. So from a bank’s perspective its capital is its own ‘safety net’ that must be preserved at all costs. Without adequate capital a bank simply won’t lend. Instead it will hoard its income in order to build back until it has an adequate capital base again. Then it will restart lending.

The flood of losses, mainly from bad housing loans, that swept through banking in late 2007 and early 2008 reduced bank capital to a threadbare minimum. The effects of these losses on the capital markets [a generic phrase covering a variety of specialty markets] was to undermine confidence. Banks became fearful of doing business with each other because they had no idea whether they would get their money back. The result was to drive interbank interest rates up to historic highs with some money markets stopping altogether. Since the credit markets are central to the economy as a source of funding business immediately suffered.

TARP was designed to help restore confidence by eliminating bad assets and thus reassuring the banking system that interbank trade could return to normal. Once that happened the notion was that markets would calm and business could also return to normal.

The problem was that banks were then facing a different issue. The non-financial economy began to slide into recession. This is a separate, though obviously related, problem. The financial crisis TARP was supposed to deal with was restricted to the credit system, but now the ‘real economy’ was also in decline. This meant that banks would have to deal with a second wave of losses from commercial and personal loans. That second wave would undo all the good work that TARP had fixed.

When it realized this story was unfolding the Treasury Department backed away from the original plan. In fact it never implemented it. Instead it switched to a plan of using the TARP money to inject capital directly into banks via a number of means including the purchase of preferred stock. So the government began to become a shareholder of some of largest banks rather than an owner of wads of bad assets.

This switch is the core of the problem. Banks have been given infusions of cash, but they have been slow to lend it because they are waiting for business conditions to improve – they want to be repaid – and they are still concerned that they need to hoard capital in the face of the mounting second wave of expected loan losses. So the banks have acted prudently [its about time!], but have frustrated lawmakers who thought the money in TARP was going to flow into the economy in the form of loans.

It seems that lawmakers don’t understand banking. If they had wanted to make sure loans were gong to be made they should have relieved the banks of having to keep capital. The best way to do this is to nationalize them. State owned banks don’t care about hoarding capital because they know the government can always print more money to replace any losses they incur. Privately owned banks don’t have that luxury. Private shareholders want to know that the banks they own are acting to preserve capital and are not being profligate with shareholder funds. So TARP ran afoul of sensible banking. What it has achieved is to prevent some banks going bankrupt and to provide a temporary bulwark against the erosion of capital. It could never have created lending because banks simply want to stay afloat through the recession and the best way to do that is not to lend. Because America won’t nationalize its banks [other countries like Britain and Sweden don’t worry about nationalization] it has to muddle through by injecting enough capital into the system to ensure its solvency. By my estimate that means that the bailout is only half done. The potential for losses is still there as the economy wallows in recession. That means banks will take hits to capital from loans they have already made. They have no incentive to add to the problem. Until business conditions improve the Treasury Department will have to pump money into banks and accept that no new loans will be made.

So my advice to lawmakers: get the economy rolling again and stop fussing about lending. Support the stimulus package. A healthy economy will find that bank loans are plentiful.

Note:

Bernanke made a speech at the London School of Economics [gotta plug the alma mater] during which he raised to prospect of more bank bailout money being needed. Here’s the story from the New York Times: Banks In Need of More Bailout Money?