What the Government Should Consider

Banks are being criticized for not making enough loans. Banks are being criticized for making loans to companies that are experiencing financial difficulty.

Critics of the failure to lend tend to be politicians who want their constituents to think they are working hard to resolve our economic situation and that someone else is the "bad guy." They have the power, collectively, to enact laws that affect banking.

Critics of loans that are not performing as expected are accountants, auditors and bank regulatory agencies - including the Federal Reserve, FDIC, Office of the Comptroller of the Currency (a department of the U.S. Treasury) and virtually all state bank regulatory agencies. They have the power to close banks without any hearings or other public "due process" proceedings.

If you were a banker, which group of critics would be most influential in the short-term? The obvious answer is the second group - the regulatory agencies.

No competent banker would ever intentionally lend money to an individual or organization where payment is clearly highly unlikely. Hundreds of thousands of individuals are becoming unemployed on a monthly basis. Companies are experiencing severe drops in demand for their products and services. Profits are down and formerly healthy companies are closing. Bankers are going to be extremely cautious when they are approached by potential borrowers. Credit will only be extended to entities deemed to have the least amount of credit risk.

If the solution to our economic situation is to extend credit, perhaps the federal government should find a way to guarantee or participate in the lending process. If my bank received a capital injection from the federal government, would I expect it to rush out and begin making higher risk loans? Why should it? The bank expects to return the capital to the government and the government expects to be paid back. That can't happen if the bank starts making loans that may not be repaid. Would I lend money to an entity if the federal government guaranteed repayment? Why not? Would a bank need additional capital to make a government guaranteed loan? Why should it?

Another aspect of the economic situation as it relates to banks is liquidity. Some forced bank closings and "sales" have resulted from a lack of liquidity even though they had adequate amounts of capital to meet legal and regulatory formulas. Isn't it amazing that a bank with a liquidity problem is often precluded by law from accessing common sources of liquidity such as brokered CDs? Perhaps it is time for regulatory and legislative bodies to re-think the consequences of these laws and regulations.

December 19, 2008

Article in the Financial Times seems to support the above concept. See http://www.ft.com/cms/s/0/42a1c58e-cd70-11dd-9905-000077b07658.html