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Waiting for Banks to Lend Again May Require Patience



Why haven't banks begun to lend?

When the Bush administration finally persuaded Congress to approve the $700 billion Troubled Asset Relief Program in September, the main objective was for the Treasury to purchase the most "toxic" bank assets in order to get the banks to free up lending again. Later in October, the administration shifted course and decided the best way to achieve that objective was to use at least some of the funding appropriated by Congress to buy stakes in the banks themselves. But despite the promise of capital injections, anecdotal evidence suggests that the banks remain reluctant to lend, and in some cases are talking of using their new capital injections to buy other banks.

The apparent disinclination of banks to open up the lending spigots is hard to measure, and it arises from a number of complicated factors. If you look at the bank balance sheet numbers, you see the volume of loans on banks' balance sheets has been roughly constant throughout 2008.1 It is difficult to see what is going on in overall lending from the balance sheet levels, however, since the dollar volume of loans on banks' balance sheets would only decline gradually even if banks cut off all new lending. The lending slowdown is more readily apparent if one looks at loan growth, which has been declining since the beginning of the year. Not surprisingly, the decline began earlier and has been steeper for real estate loans.2

As a rule, bank loans tend to lag the economic cycle, not lead. (2001 is something of an exception in this regard.) Accordingly, the worst of this economic downturn may be ahead of us. Moreover, increased borrowing does not necessarily portend an economic improvement because some forms of borrowing can rise during the early stages of recession. For example, some firms need to finance their accumulating inventories.

The first point about bank behavior is obvious, but nonetheless is worth making. It is absurd to think that the equity injections announced just a couple weeks ago would have had any effect whatsoever by now.

Second, the equity injections were surely intended to bring banks back up to a reasonable capital ratio (once all the losses are written off) of 8 to 10 percent. It would be interesting to know what the capital ratios are like now, but for that you have to look at the call report data and that takes a lot of time, effort, and expertise. It is reasonable to assume, however, that with all their reported losses, many banks remain seriously undercapitalized. Bringing them back up to decent capital ratios is a good idea because, as we know with the Savings and Loan debacle of the 1980s and 1990s, poorly capitalized institutions tend to do erratic things, including the pursuit of high-risk schemes in an effort to save themselves. Using the capital injections to make new loans would of course be beneficial to those who need the credit, but it would move those capital ratios back down again. It is understandable that banks would not want to do that, since they are surely concerned about more losses coming down the pike. (Check out the chargeoff and delinquency rates.) These charges have already jumped, and chances are they will continue to climb. And you can be sure that the regulators would like to see the banks maintaining an 8 percent plus capital ratios, especially now.

Third: Another good reason to inject some public capital into the banks is because it will make it easier for them to raise fresh private capital. Investors hate to make equity investments in institutions whose probability of bankruptcy is nonzero. The reason is that, in the event of bankruptcy, debt holders get their money. This is known as the debt overhang phenomenon, and it is an important issue these days. If the public equity injections did nothing but facilitate private equity injections, they would have been worthwhile.

Fourth: We never get to see the counterfactual. Suppose the banks get their capital injections, and lending continues to decline. Will the program have been a failure? Not necessarily. We don't know—and we can never know—how bad the dropoff in lending would have been in the absence of the capital injection, but it's reasonable to conjecture that it would have been worse. One thing we do know is that poorly-capitalized banks tend to offer loans on less favorable terms than well-capitalized banks (see my paper with Hubbard and Palia in the 2002 Journal of Business). Consequently, even if we agree that restarting bank lending is the criterion for judging the success of the capital injections, gauging their success is going to be difficult.

Fifth: Who is to say that demand for certain kinds of loans isn't falling? Is it reasonable to think that real estate developers are queuing up to obtain financing for new tracts of homes or mini-malls?

The bottom line is that it is simplistic to expect the Treasury's equity injection to affect bank lending right away. This is a long-term problem, and the equity infusion is a long-term remedy. Recall that in Japan, chronically undercapitalized banks dragged the economy into a decade-long period of stagnation. The best-case scenario is that rapid recapitalization will spare us that long adjustment process, and give us a shorter—two to three years?—period of stagnation.

Figure: Real Estate Loans at All Commercial Banks

Source: Board of Governors of the Federal Reserve, release H.8 (data accessed via the Federal Reserve Bank of St. Louis's Fred database).

Kenneth N. Kuttner, professor of economics at Williams College, was a visiting fellow at the Peterson Institute for International Economics in 2005-07.


1. As gauged by the data on "total loans and leases at commercial banks," from the Fed's H.8 release.

2. "Real estate loans at all commercial banks," also from the Federal Reserve's H.8 release.

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