We’re getting questions about whether banks that receive taxpayer funds from the Treasury are “hoarding” that cash, rather than using it to support lending.

We know that banks aren’t hoarding yet, since at most they’ve had cash for two days.

Remember that there is a two-fold purpose to this program: (1) strengthen the banking system (prevent a collapse), and (2) increase lending.

We think that profit-maximizing banks have an incentive to lend.

In some cases, when a bank does not use new capital to support additional lending, they are still accomplishing our policy goal of a strengthened financial system.

So while we can’t tell you that the anecdotal reports of other plans for the cash are provably wrong, we think these reports are largely distractions from what banks will actually do with your tax dollars.

And we believe the “solutions” that are being suggested to “ensure” that every taxpayer dollar goes directly to support more lending would be counterproductive. We want banks to use the taxpayer investments both to strengthen the banking system and to increase lending. Since this is a voluntary program for banks, we cannot mandate the specific use of each taxpayer dollar, and if we try, banks won’t participate.

Banks are undercapitalized. They need more capital so that:

  • they can increase their capital cushion, and thereby lower their probability of being insolvent;
  • other banks and other financial institutions have the confidence needed to loan them short-term funds; and
  • they can support more lending.

There are three goals here, not one. If a bank takes an equity investment and if that investment helps with any of the above goals, that’s a good thing. The most effective way to increase lending is to move toward a banking system that has more capital, more liquidity, fewer projected failures, and is more efficient than today’s system.

If, for instance, a bank has a capital hole because it lost a lot of money on bad investments in mortgage-backed securities, and if it’s at risk of being insolvent, then more capital will reduce that risk and make it more likely that that bank will continue operating and (eventually) lend more. Even if that bank doesn’t use this specific investment from Treasury to support more lending, but instead to strengthen its own capital cushion, if that taxpayer investment keeps that bank from going out of business, that’s a good thing, and lending will increase over time.

Similarly, if a bank takes an equity investment from Treasury, and uses some of that investment to buy another bank, there’s a good chance that the bank being purchased is in weak financial shape and at risk of going bankrupt. The taxpayer investment is therefore going to keep that lending capacity in the system, and to provide a strong capital cushion for the new combined bank. Again, while there’s no new immediate lending in this specific case, the outcome accomplishes one of our goals – lowering the probability of a bank going bankrupt.

Now suppose a bank takes some of the Treasury investment and keeps it as cash in their vault. Is that a bad thing? Not necessarily. In a highly volatile financial environment, it may make sense for an individual, business, or bank to keep more cash on hand, just in case they need it. In this case, some of that equity investment may strengthen a bank’s liquidity as it adapts to an environment with skittish depositors, borrowers, and lenders. That’s not directly supporting new lending, but increased liquidity is still a good thing that makes the banking system work better.

Banks make money by lending. And these taxpayer investments are not free to the bank – the bank must make dividend payments to the Treasury for that investment. The terms of the agreement are that each bank must pay a fixed 5 percent dividend for the first five years, and then a fixed 9 percent dividend after that. So unless a bank wants to lose money (and we can safely assume they don’t), they will need to get a return of better than 5 percent to make the investment worthwhile. Simply put, we expect that banks will work to maximize their profit, and that most will do that by lending to businesses and consumers, and that they will take some of the returns from that lending to pay back the Treasury/taxpayer.

If a bank uses more capital to do something unproductive (like pay their employees bigger bonuses), rather than to strengthen their capital cushion (good), buy another failing bank (also good), or support more lending (even better), then we think that bank could be losing money on their new investment, since they still have to pay Treasury a 5 percent dividend. And the law requires that banks that take an investment limit the compensation of their highest-paid executives.

Finally, it’s impossible for more than two days of hoarding to have occurred so far. It took some time for all the lawyers to work out all the details, and the cash is just now beginning to flow. The first cash left the Treasury Department on Tuesday. So the press reports you may have seen are entirely speculative reports of what some claim they may do with their new capital.

What about the NY Times’ proposal?

If Treasury won’t impose conditions, Congress must, including a requirement that banks accepting bailout money increase their loans to creditworthy borrowers and limit their acquisitions to failing banks, such as those listed as troubled by the Federal Deposit Insurance Corporation.

This is a stunning suggestion. Part of the reason we’re in this financial mess is that the government pushed lenders to make loans that didn’t make financial sense.

There is a philosophical difference here. Our approach is to create incentives for banks to strengthen themselves and the economy by relying on a profit motive. The NY Times’ approach is to try to have government mandate certain outcomes by force, and tell banks, “If you take this investment, you must do X, Y, and Z with the money, and you must not do A, B, or C.” The law already requires:

  • limits on incentive compensation for senior executives;
  • clawback of compensation for senior executives if financial statements are later proven to be materially inaccurate;
  • prohibition of “golden parachutes”;
  • a new limit on tax deductibility of executive compensation; and
  • for those firms that take an equity investment, restrictions on dividends and share repurchases.

The Times forgets that this program is voluntary. If the government tries to mandate a use for the funds that a bank would not otherwise choose to do, that bank just won’t take the funds. Make the requirements and restrictions onerous enough, and you’ll end up right where we started – with a dangerously undercapitalized banking system.