Why Banks Need to Lend Out Their TARP Funds

Justin Fox likes Jack Guttentag's argument as to why it makes sense for banks to sit on TARP funds rather than lending them out. I don't.

Guttentag defines a bank's capital as "the difference between its assets and its debts", and adds:

The major role of capital is to absorb potential losses on the assets, some of which will default. A closely related role is to instill confidence in the firm's creditors, whose concern is always whether or not capital is sufficient to absorb all losses. If it isn't, the firm may not be able to repay its creditors.

On this view capital is not in any way a debt of the company, and anybody providing capital can not be considered that company's creditor.

But look at the capital which the government provided to the banks: It took the form of preferred shares, which can also be considered to be very junior debt. These shares come with no ownership or voting rights; instead, they just pay a fixed coupon every six months, just like the bank's debt. From the bank's perspective, it's borrowing money from the government, and has to pay that money back with interest.

If the bank really used the government's capital to absorb losses, and defaulted on its obligation to preferred shareholders, I can assure you that would instill no confidence whatsoever in its more senior creditors. Indeed, from those creditors' point of view, the bank has simply increased the amount of money it needs to pay in interest every year, without increasing at all its tangible common equity.

Because the government's capital infusions come with the obligation for banks to repay Treasury with interest, those banks have to lend that money out, in order to start being able to make some profit on it. Otherwise, they just get closer and closer to default -- not on their senior debt, perhaps, but certainly on their preferred shares, which would still constitute the end of the bank as we know it.

Yes, the banks have increased their regulatory capital, which is important in terms of keeping certain important ratios where they need to be. But that's just the beginning of what they need to do. The next step is to start lending that money out. If they don't do that, they're doomed.

Comments

[Moon Kil Woong:]

Why should banks lend out? They are doing fine except the few like Citi and Goldman. And even they are not doing shabby. After all they can't go bankrupt and get billions every few months for free.

In fact not only are their executives sitting pretty with millions in salary for ruining their fine institutions, they are rewarding themselves with bonuses for a good job pandering.

Economically speaking they are even in a good position. They are getting richer relative to everyone else by the day. I think they are playing a zero sum game theory here. By the time you have nothing they will have everything. Capitalism at it's worst. Especially when the assets they have came directly out of your pocket.

So as you can see, banks have no reason to do anything but watch you starve. Especially now they can leave all the deposits at the Fed and get interest at no risk. Some would call that welfare. but not bankers. They will say, "That's not welfare. Now see that. That's called TARP. Now that's real welfare. The type you can really sink your gold teeth into."

Jan 13 01:07 PM

[Pent up demand:]

The idea of immediately lending out these TARP funds presupposes the existence of borrowers ready to put the money to work in some way that is a net economic positive. We are in the process of tearing down a massive edifice built on misallocated capital, but the government and the financial press are ready to get right back on that horse and misallocate some more dollars. Yee haw. Ride'em cowboy!

Jan 13 01:27 PM

[jamesa40:]

Exactly. Lending for lending's sake is what got us into this mess in the first place. Banks have been and will continue to lend (for proof, check out this link www.bankstocks.com/Art...

Anyways, the problem is that banks are not lending the way that congress wants them to (aka. giving the money away) and thus they are trying to rewrite the rules. If they put these requirements into effect, you will see the largest prepayments back to Uncle Sam of TARP money one could imagine. Will congress then claim victory, or will they still be in the same place or worse, have more banks out there without an adequate capital cushion?


On Jan 13 01:27 PM Pent up demand wrote:

> The idea of immediately lending out these TARP funds presupposes
> the existence of borrowers ready to put the money to work in some
> way that is a net economic positive. We are in the process of tearing
> down a massive edifice built on misallocated capital, but the government
> and the financial press are ready to get right back on that horse
> and misallocate some more dollars. Yee haw. Ride'em cowboy!

Jan 13 01:44 PM

[E Thomas St.:]

Given the rate on the coupon banks pay out to the government what is the lowest interest rate they could charge on the loans they would provide for their customers?

Sitting and waiting at least has defined parameters of the loss to the banks where as lending that money out exacerbates risk and might not even be possible at a profitable rate.

Jan 13 03:04 PM

[Smarty_Pants:]

The TARP keeps lending and the band keeps playing, but the roadies are packing up all the chairs. Soon enough the band will stop playing and there won't be anywhere to sit.

Good points in the replies. Lending out money you owe to somebody else is the only way to earn enough to pay off the TARP interest obligations, but it also needs some productive use for it to make any sort of economic sense. Making loans to fund vacations in the Bahamas won't generate any sort of income stream from which to repay the loan.

Given that consumers are retrenching, there also aren't that many expanding productive enterprises springing up (save for new lobbying concerns in DC) where those loans would support their payment obligations.

Fact is deflating credit bubbles suck and we're going to have to simply take the kick in the gut that's coming our way. Hiding the act under a TARP won't make it hurt any less.

Let's not forget that lending out the $500 Billion of additional base money at fractional reserve multiples could add as much as $5 Trillion to the circulating money supply. More loans means the arrow on the inflation meter starts spinning faster and faster.

Jan 14 10:11 AM