In a recent post on the money multiplier, a reader Luis Enrique asked about bank lending and capital constraints. Anecdotally, much of the reduction in credit is supply-constrained as well as demand-constrained. That means it’s a matter of banks not lending; it’s not just about firms and individuals not borrowing.
Banks are capital-constrained even if it seems like they are making lots of money. We are in what I called the fake recovery in April 2009. I said then:
In truth, the U.S. banking system as a whole is probably insolvent. By that I mean the likely future losses of loans and assets already on balance sheets at U.S. financial institutions, if incurred today, would reveal the system as a whole to lack the necessary regulatory capital to continue functioning under current guidelines. In fact, some prognosticators believe these losses far exceed the entire capital of the U.S. financial system…
Now, obviously, if we were to face up to this situation, there would be no chance of recovery as the capital required to recapitalize the banking system would mean a long and deep downturn well into 2010 and perhaps beyond. This is not politically acceptable as 2010 is an election year. Nor is the nationalization of large financial institutions acceptable to the Obama Administration. Moreover, bailing out banks to the tune of trillions of dollars while the economy is in depression is equally unacceptable to the American electorate. The Obama Administration is keenly aware of this fact.
I go on to mention six methods of engineering an unsustainable fake recovery in the hopes that time and a steep yield curve will surreptitiously recapitalize banks. The most important aspect of this fake recovery in regards to lending is the end of mark-to-market. I said at the time:
End of mark-to-market as we knew it. You should have noticed that most of the assets written down in the past two years have been marked-to-market. Securities traded in the open market are marked to market. Loans held to maturity are not. This is one reason that large international institutions which participate in the securitisation markets have taken the lion’s share of writedowns, despite the low percentage that marked-to-market assets represent on bank balance sheets. But, this should end because of new guidelines in marked-to-market accounting. However, the new guidelines do have two major implications. First,there are still many distressed loans on the books of U.S. banks that if marked to market would reveal devastating losses. Second, there will also now be many distressed securities on bank balance sheets that if marked-to-market would reveal yet more losses. In essence, the new guidelines are helpful only to the degree that it prevents assets being marked down due to temporary impairment. If much of the impairment is real, as I believe it is, we are storing up problems for later.
Now, bank insiders are no dummies. They know their true capital position and are not lending as a result. Here’s my narrative on how this works in practice:
Let’s look at this from the point of view of a big bank CEO who we will call Phil.
Now, Phil was caught unawares when the credit crisis hit. His bank, where he had been CEO for a decade, had been growing prodigiously at relatively low risk according to internal risk metrics. The return on capital was top quintile. But, the financial crisis and recession had not been kind to the bank. Big Bank had taken massive credit writedowns and was forced to take on TARP money and issue FDIC insured bonds in order to demonstrate its safety as a bank. As a consequence, the share price was crushed, falling 80% peak to trough. All of Phil’s stock options were underwater.
But, the stress tests showed that Phil’s bank was in relatively good shape – at least compared to Big Bank’s peers. On the back of this information, Big Bank was able to issue a huge slug of new shares at a price 200% above its trough share price and fill any apparent gaps in Big Bank’s capital. In fact, under the guidelines of the stress test, Big Bank could pay back all of the TARP money it received and return to business as usual.
There was one problem, however, and Phil knew it. You see, Phil had become a lot more worried about the health of his bank after being caught flat-footed when the credit crisis hit. The company had done a significant amount of work to get to grips with likely credit exposure. And while the situation was good for Big Bank under the conditions predicted in the government’s stress tests, Phil knew that the conditions were not good at all in more adverse scenarios. What should Phil do?
The prudent thing to do is not lend, of course. And this is what banks are doing- reducing credit availability, despite the increase in bank reserves. They are lending to the most creditworthy borrowers but they have tightened lending standards – and that generally has meant individuals and small businesses get hit harder. See here and here.
In my April post "JPMorgan is not substantially increasing lending anytime soon" I said JPMorgan Chase (JPM) has not increased its dividend to a normal level. That tells you they are capital-constrained. And I see them as the best-capitalized too-big-to-fail commercial bank.
For a fuller accounting of the accounting subterfuge, read here (On releasing Citi from TARP and banking by accounting subterfuge) where I say there is more to banks’ capitalization than meets the eye as we saw during the S&L crisis, by the way.
Bill Black is making similar comments.
“The FDIC is sitting there knowing that it has both the residential disaster and the commercial real estate disaster [and] knowing it doesn’t have remotely enough funds to pay for it,” he says.
The video is below. It’s very good. Also see "The FDIC acknowledges it is to run out of money" from last year which made the same points last year.
All of this is my long-winded (and hopefully fully-linked and well-documented) way of saying banks are reducing lending because they are capital constrained. It’s not just about the borrowers. The mark-to-market change is accounting subterfuge that allows banks to pretend they are well-capitalized (and pay large bonuses too). In a perfect world, the government wouldn’t condone this. But we don’t live in a perfect world.