What Will Induce Banks to Make Riskier Loans?

I rather like this bit of CNBC interview with Ken Lewis, helpfully transcribed by Calculated Risk:

Q: What about capital adequacy. Are you expecting to raise new capital?

Lewis: We are not expecting to need more capital. The issue of course - which was brought up today which is hurting all bank stocks - will some be required convert some of their preferred to common. We don't think we have an issue there. But that is now in the hands of the regulators, and we have not heard back from them at this point in time.

Q: What should we look for as far as the most important things to come out of the stress tests?

Lewis: I think it will be what requirements are there on what banks in terms of conversion of TARP preferred into TARP equity.

Q: You said you want to pay back the TARP money in 2009. Is that still on the table? Are you expecting to pay back that TARP that soon?

Lewis: Well, we would like to, and we would prefer to. But again that is now in the hands of the regulators and we will be in consultation with them as to what the best avenue will be in that regard.

Lewis makes it sound (accurately, I think) that there is little agency for banks in these decisions, at least for the shakier of the bunch. What will be will be. The government will figure out how big a capital hole it will need to plug and plug it, and Lewis will continue to look forward to paying back TARP -- as soon as Treasury says it's ok.

Fear government control in a nationalization scenario if you want, but it's pretty clear that for the banks in dire straits, Treasury already has a heavy hand on the wheel. And increasingly I'm inclined to see the Treasury as herding banks into different categories -- those it can wean off support, and those who will be needing the support freed up by the weaning of the other banks. My question, of course, is where Citi goes. It needs a third category -- ?!?1!

In some ways, though, the conversion could be freeing to banks. Mike at No Empty Wallets quotes Linus Wilson on the incentive effects of changing preferred shares to common:

Even if no new money goes into banks, common stock creates different incentives than preferred. Managers, if they are doing their job, maximize the value of common stock (not preferred stock). Limited liability means that a distressed bank will have perverse incentives until it has enough common stock to absorb those losses. With too little common equity, banks will pass up good loans because too many of the gains are realized by preferred stockholders and debt holders. Managers running banks with too little common equity will be tempted to make speculative loans and shift those losses onto senior creditors (preferred stockholders and bondholders).

That's an interesting argument. The tricky bit is that it's not clear to me that undercapitalized banks are making risky loans, even though proponents of nationalization have maintained that that's the natural incentive for managers of insolvent institutions. But this also gets at one of the key questions concerning the banking crisis -- why aren't banks lending? Some of them are, of course, but why aren't they lending more? Is the problem a decline in demand for credit or is it directly related to balance sheet issues? The import of the point is this -- as demand for credit grows with recovery, will the sick banking sector constrain growth, or will healthier banks and other credit markets meet the demand?

We'll see.

Comments

[Dustinian]

If only we could force our banks to lend, like the Chinese.

2009 Apr 21 11:46 PM

[PastTense]

Banks should not be in the business of making risky loans--risk-taking is what equity is for.

2009 Apr 22 12:25 AM

[Buy and Hold Plus]

Why do we want banks to make risky loans? Are we so stupid that we have already forgotten that risky loans are what got us into this mess? And we haven't even gotten out of the mess yet we want banks to go back to doing the same thing?

Are we that stupid?

2009 Apr 22 12:33 AM

[Crocodilian]

The notion that somehow we're suffering from a shortage of lending seems dubious. We're suffering from an excess of debt, relative to asset values. Lending more money against this debt doesn't do much except "kick the can" a little further down the road. You can do this a long time, to be sure, for an entire lost decade or even 'lost generation', but Japan serves as a painful example that 25 years later, if you haven't fixed the debt, you haven't fixed the system.

Banks clearly have been making "risky loans" all along, and that hasn't done us any good. Ultimately, we're going to have to reduce the role of finance in our economy-- its a useful and necessary tool, but the reason that Toyota is sitting on a pile of money and GM is broke has not much to do with the financial systems of the US and Japan-- and a lot to do with labor relations, educational standards, and national priorities.

2009 Apr 22 06:24 AM

[nobby73]

What I suggest is that the Treasury finds the traitors who haven't been borrowing enough. You know they probably don't have the latest, loudest flatscreen or newest car. They probably wear clothes that look like they have owned them for more than a year and they have likely lived in the same house for more than 20 years. Once you've located them, sent round the National Guard and hand over the loan proceeds and then march them to the nearest mall or autodealer to spend it. If they refuse, ship them off to China, or somewhere, because not being in debt is, frankly, un-American. Oh, and if they start whining about their stock portfolio having fallen 40%, gag them.

It's a surreal situation we find ourselves in, the banks are whining because they've run out of people to fleece, sorry I mean lend to, and they need more victims, sorry customers, because it turns out the last ones weren't any good.

2009 Apr 22 08:30 AM

[pockyclips 2020]

Since we killed off our manufacturing, our only alternative is to increase consumer spending. Not a lot of margin in moving stuff from Point A to Point B.

2009 Apr 22 09:06 AM

[Edward Ulysses Cate]

If you really want to understand how two insolvent financial entities can be combined and quickly show profits, here's the book.
The Best Way To Rob A Bank Is To Own One, subtitled How Executives and Politicians Looted the S&Ls.
What we're seeing today is Act II. I heard about it April 3 on Bill Moyers Journal, ordered it, and finished it a few days ago. What goes on in these control-frauds and behind-the-scenes in regulatory warfare is beyond disgusting. The author was a litigator with the Bank Board at that time. "False Profits Once Again" commentary at my website was written as I was halfway through the book.

2009 Apr 22 12:18 PM

[a fat panda]

Banks have the capital to lend. What they are missing is credit worthy customers.

2009 Apr 22 10:12 PM

[whisperonthewind]

Dustinian, more than half the problem was that banks WERE forced to make loans even when they knew they probably shouldn't. They were told to by our government. If no one had fussed with those credit restrictions, we might not be in this mess now.

2009 Apr 22 10:37 PM