Why Banks Need to Lend Out Their TARP Funds

Justin Fox likes Jack Guttentag’s argument as to why it makes sense for banks to sit on TARP funds rather than lending them out. I don’t.

Guttentag defines a bank’s capital as "the difference between its assets and its debts", and adds:

The major role of capital is to absorb potential losses on the assets, some of which will default. A closely related role is to instill confidence in the firm’s creditors, whose concern is always whether or not capital is sufficient to absorb all losses. If it isn’t, the firm may not be able to repay its creditors.

On this view capital is not in any way a debt of the company, and anybody providing capital can not be considered that company’s creditor.

But look at the capital which the government provided to the banks: it took the form of preferred shares, which can also be considered to be very junior debt. These shares come with no ownership or voting rights; instead, they just pay a fixed coupon every six months, just like the bank’s debt. From the bank’s perspective, it’s borrowing money from the government, and has to pay that money back with interest.

If the bank really used the government’s capital to absorb losses, and defaulted on its obligation to preferred shareholders, I can assure you that would instill no confidence whatsoever in its more senior creditors. Indeed, from those creditors’ point of view, the bank has simply increased the amount of money it needs to pay in interest every year, without increasing at all its tangible common equity.

Because the government’s capital infusions come with the obligation for banks to repay Treasury with interest, those banks have to lend that money out, in order to start being able to make some profit on it. Otherwise, they just get closer and closer to default — not on their senior debt, perhaps, but certainly on their preferred shares, which would still constitute the end of the bank as we know it.

Yes, the banks have increased their regulatory capital, which is important in terms of keeping certain important ratios where they need to be. But that’s just the beginning of what they need to do. The next step is to start lending that money out. If they don’t do that, they’re doomed.