As Government Officials Press Banks to Lend, What (if Anything) Are They Thinking?

Message from the president to the banks: lend! This message was made perfectly clear by White House press secretary Dana Perino, who said: “What we’re trying to do is get banks to do what they are supposed to do, which is support the system that we have in America. And banks exist to lend money.” Just in case the bankers might fail to get the emperor’s hint, Perino added ominously that the bank regulators “will be watching very closely.”

Anthony Ryan, acting undersecretary for domestic finance at the Treasury, told those attending the annual meeting of the Securities Industry and Financial Markets Association: “As these banks and institutions are reinforced and supported with taxpayer funds, they must meet their responsibility to lend, and support the American people and the U.S. economy.” Like Perino, he felt the need to add a thinly veiled threat: “It is in a strengthened institution’s best financial interest to increase lending once it has received government funding.”

So much for the idea that because the government is taking nonvoting preferred shares in exchange for its handouts, it will have no influence over how the privileged banks are managed. Indeed, the idea that it would keep its hands off was always preposterous, regardless of the formal status of its newly acquired ownership stake. In view of the many ways in which the government can hurt a bank whenever it wishes to do so, no ownership position was necessary in any event.

As always, government officials are worshiping at the altar of easy credit, confident that any economic problem, no matter what it may be or how it may have arisen, can be solved by dumping cheap credit on it. Evidently, government leaders have not paused to reflect on how the economy came to be in its present troubled condition.

If they had given the matter any informed thought, they would have realized that outpourings of cheap credit lie at the root of the entire sorry situation. Recall how the Fed pushed the Fed Funds rate down to 1 percent in the wake of the dot-com bust of 2000-2002. With Fed credit available to banks for years on end at a negative real rate of interest, how could they resist plowing ahead with loans that normally would have seemed absurdly risky, especially when they could pass much of the rotten paper along to Fannie, Freddie, and other buyers in the secondary market? The rest, as they say, is history.

Now, the banks and other lenders have been chastened by the nasty turn of events during the past year. Giants such as Bear Stearns, Lehman Brothers, AIG, Wachovia, Washington Mutual, Merrill Lynch, Fannie Mae, and Freddie Mac have drowned in the swift currents stirred by years of feckless lending. Lenders have properly become more cautious. Eager to rebuild depleted capital and reserve balances, they are reluctant to lend except to clearly creditworthy borrowers. Riskier borrowers, if they are served at all, must pay hefty interest-rate premiums to compensate the lenders for dealing with them.

So, the present so-called credit crunch deserves to be recognized as an exhibition of prudence, which now reappears after a long absence, whereas the credit markets during the past five or six years deserve to be recognized as an exhibition of a fool’s paradise. Seemingly too good to be true at the time, they were, indeed.

Yet, in this concert hall, the government knows the lyrics to only one song: lend, lend, lend. Worry not about the morrow. After all, should you get into trouble, you can again draw from the government’s bottomless well, which is fed by its base-money fountain, to slake your thirst for another bailout.

So far, however, the banks have chosen to allow their reserves at the Fed to build up astonishingly.  For the week that ended September 10, reserve balances with federal reserve banks averaged $8 billion. Then they began to increase rapidly, and by the week that ended October 22, they averaged $301 billion.

Although reluctance to lend to poorly qualified borrowers may explain a large part of this buildup, we might also note that on October 6 the Fed announced that henceforth it would pay interest on required and excess reserves, thereby greatly increasing the incentive for banks to hold the latter. So, on the one hand we see the government giving banks a reason not to lend out excess reserves, but to hold them in a riskless form while nonetheless earning interest on them, and on the other hand we see the government threatening banks that do not lend out their excess reserves, regardless of the risks associated with such lending in the present circumstances. If you suspect that the left hand does not know what the right hand is doing, you may well be barking up the right tree.