The Fed Has No Leverage: Bank Lending Remains Moribund

The Fed made hundreds of billions of dollars in short term loans to banks. It was necessary, in the opinion of the agency, to do that to preserve the financial system as we have known it for decades. It is unlikely that the more permanent TARP facility would have been approved by Congress if the Fed had raised any reasonable objection.

The salvation of the banking system was a brush with a sort of financial socialism. It did not become full-blown because the financial firms that were rescued were never forced to do very much in return. The list of what was expected of the banks was not very long, and they have done virtually none of it. The firms might make the argument that they attempted to modify some home mortgages to keep a limited number of people in their houses or made small business loans which had the backing of the government. The reality is that the paperwork and time that bank workers have to devote to these projects is too expensive to make them worthwhile even if there was a case to be made that they would benefit the larger, national economic good.

The government also told banks that excessive compensation, a concept the has never been properly defined, was against the best interests of taxpayers who bailed out the banks and the shareholders, many of whom lost most of their money in Citigroup (C), Bank of America (BAC) and their peers. The Administration has tried public humiliation as a means to curtail big pay packages. The boards at Citi and B of A have been largely replaced by people hand–picked behind the scenes by the government. That has not helped in a case where Citi owes one of its traders $100 million. He has a contract, which has a moral imperative all its own, and the man will almost certainly get what is due him.

The banks that have paid back the TARP funds make a compelling case that the government has no right to say how they will pay people.  The memories of these bankers are conveniently short, given what the Treasury and Fed did for them in their time of crisis. The Administration insists it will remind them clearly by putting a “pay czar” in place to harass the firms and act as ballast as the banks move back to the huge compensation packages which were the norm just two years ago. Kenneth Feinberg, who has taken the czar’s role, claims he has power which is so vast that he has the ability to “claw back” compensation made before 2009. That may pit him against provisions of contract law, but the government is probably able to fight that issue in court longer and harder than any individual banker can.

Setting aside the disputes between the government that believes it saved the banks and risked taxpayer money in the process and the banks which want to make the argument that, profitable again, they should control their own fortunes, the most basic request that the Administration has made has been left unmet. Documents released by the Fed show that “based on responses from 55 domestic banks and 23 U.S. branches and agencies of foreign banks “ the process of making loans will remain tight for several quarters. The Fed may not say it, but that could undermine the recovery. The July 2009 Senior Loan Officer Opinion Survey on Bank Lending Practices reports that in the survey, domestic banks indicated that they continued to tighten standards and terms over the past three months on all major types of loans to businesses and households, although the net percentages of banks that tightened declined compared with the April survey. In addition, most banks reported that they expected their lending standards across all loan categories would remain tighter than their average levels over the past decade until at least the second half of 2010. In other words, the banks will, probably appropriately, put their own interests ahead of those of the economic recovery.

The problems with the positions the banks are taking is two-fold. First, without adequate liquidity there will obviously be no recovery. The financial firms may not be feeling the bit of a recession that goes on for another year or two, but they will eventually. Their earnings cannot withstand an environment of rising defaults and falling bases in their asset management business.

The other problem is no less subtle, but the banks would like it to appear that it is. The government did not save the banks so that they could undercut the recovery. It is clear from what has happened to date that the Fed and Administration have no plans to put unrelenting pressure on the banks to open their wallets. All of the parties involved, the banks, those they might lend money to, the government, and the taxpayers may regret that the private sector financial system has not been forced to be more liberal in its lending practices, but that would be a sort of socialism that is outside what the government will tolerate; even if such socialism would have been in the best interests of the country.

Douglas A. McIntyre