TARP Repayments: Good or Bad?

Maybe I am the only one, and that wouldn’t be the first time, who thinks that the rush by some of our larger banks to repay the TARP money they received from the government is a bad thing. Rotten in fact. It seems fairly obvious to me: we pumped a ton of money into the banking system ostensibly to provide capital. Without sufficient capital none of the big banks can lend. Some are even border line insolvent depending on the mood of the accountants and the applicability of mark to market accounting.

Now, post stress test, the administration seems to be taking a very lenient approach to these same banks. Those that performed well in the tests – the ‘A’ students – have all rushed to gather in private capital so that they have the cash to repay the government.

That sounds great. The taxpayers will get some of their money back. Probably well before it was expected. So the banks that have raised extra capital now have a much better set of capital ratios and are presumably on a sound footing. Hopefully they can go about the business of banking once more.

But, if they use the cash they raised to repay the TARP money their ratios are not improved at all. There will have been no improvement. We will be back where we started. Yes the banks who repay will be off the government’s immediate dole – they will still rely on the implicit guarantee that is the ‘too big to fail’ rule – but they will be no stronger.

Self-sufficiency is one thing, hobbled self-sufficiency another.

Surely the objective of public policy should be to re-establish a strong banking industry capable of supporting a general economic recovery. The stress tests purported to create a greater degree of confidence in the system by identifying the capital shortfalls each large bank had, making that information public, and then giving the banks deadlines to overcome the deficiency.

How shedding government support fits with that policy I don’t quite see. At least not yet.

There seems to be a happy coincidence of ulterior motives at work.

The banks, naturally, want to get the government out of their hair. In particular they want to shake loose public control over their pay structures. Bankers find it offensive that their bonuses come under public scrutiny, so there is an urgency to their efforts to repay TARP money that is driven not by strategic or capital strength goals, but by more venal and personal goals.

Simultaneously, the administration wants at all costs to avoid asking Congress for more cash. While our focus has been on the top tier of banks who managed to trash the economy as they looted their shareholders and depleted their capital, there are some 7,900 odd other smaller banks beneath them many of whom need help. With TARP money now almost fully allocated, with the insurance industry now also being supported, and with an expected wave of credit card and commercial real estate losses on its way, it would be very convenient to have some of the TARP money back in the Treasury Department’s accounts available for allocation to the smaller banks.

The stress tests were never applied beyond the 19 largest banks, but some analysts have taken the methodology and performed their own tests on at least the second tier of banks – there’s about 200 of them. The results generally show that those banks are short of capital already. The Financial Times analysis, which was carried out on their behalf by Sandler O’Neill, a firm that specializes in banking industry analysis, shows that the shortfall may be as high as $24 billion. In fact according to that study 38% of the 200 second tier banks have shortages which accumulate to combined shortfall of $16.2 billion. The remaining 7,700 smaller banks need a combined $7.8 billion.

So the happy coincidence I mentioned above would both free up money to support these smaller banks and liberate the larger banks from the constraints of government oversight.

But is it good public policy?

I don’t think so.

The industry has yet to prove it can manage itself safely and avoid the need for further aid. All the evidence points in the opposite direction: the big banks all appear to want to get back to business as usual. Hence their rush to rid themselves of the pesky regulators. That’s not healthy.

As long as the ‘too big to fail’ rule still exists the big banks are operating within the ambit of implicit government support. One consequence of this is that the market will feel able to lend to them at prices below the levels that would apply to banks without a guarantee. Obviously banks without a guarantee are riskier from the market’s perspective. That implicit guarantee, i.e. taxpayer backing, is, in other words, lowering the cost of doing business for the big banks. Their profits depend on our implied support. By extension: so do their pay structures.

Were the banks truly independent and free of taxpayer backing then I believe they should be allowed to do whatever they want. They could take whatever risk they liked and if it didn’t work out they could fail. But as long as we are forced to bail them out I think we have the right to interfere in their operations, even to the point of limiting bonus payouts.

And in order to be able to assert our rights most effectively we should leave our TARP money with them as a way of tethering them down.

So the repayment of TARP money contradicts public policy on two counts: it weakens bank capital by depleting the cash they have just raised privately; and it severs a crucial control mechanism through which the government can prevent shareholder looting by management.

There are two conditions, which if met, that mitigate my objections to TARP repayments: the banks have to demonstrate their ability to avoid the errors of the recent past; and they have to be small enough to be able to fail without damaging the economy. Neither of these conditions is remotely close to being satisfied.

The TARP money should stay where it is.