December 15, 2008 by Guest Contributor

By: Tom Hannagan

For the last 16 months or so, the financial services industry has been indicted, tried, found guilty, sentenced and duly executed for ignoring accepted enterprise risk management practices.  Banks, albeit along with goofy risk ratings agencies, lax regulators, and greedy leveraged investors, have been blamed for abandoning normal and proper credit risk behavior and lending to many who did not meet basic debt servicing capability. After things went terribly wrong in capital and liquidity markets, followed by a now-official recession in the “real” economy, banks have tightened lending standards.  (See my blog posted November 13th for more about tightened lending.)

Now, following the TARP capital infusion, the press and Congress seem very upset that banks aren’t rapidly expanding their lending, or even moderating their credit risk regimen.  This dismay, with the lack of an immediate expansion of credit granting, occurs in the face of what the same press and most politicians refer to as the greatest economic meltdown since the Great Depression.

Granted, banks are historically easy whipping boys, but they now seem damned for what they did and damned if they don’t do some more of it. Although suffering in many ways, most banks are still for-profit organizations. Contrary to popular belief, they also actually have credit policies and processes that are aimed at responsible credit risk management – at least for the loans they intend to keep on their own books. Average management intelligence would dictate being cautious in the middle of an economic downturn.

The TARP capital infusion is a sudden large windfall of new equity, like a 20 percent increase for the receiving banks. It begs the question of what to do with it. To grow assets proportionately to the TARP infusion would mean a very rapid (circa plus 30 percent) growth in lending in a very short timeframe. Given the prevalence of banks, it would be very difficult for all of them to grow their loan portfolios this fast even in a good economy.

Most banks do not need TARP funds to survive in the short term. And the weakest banks are not supposed to be granted TARP funds. This is like a steroid shot into the natural process of bank consolidation. It’s obvious that the stronger banks, now infused with hot capital, are using TARP funds to acquire other banks. In many cases the acquired banks have weaknesses that they could not likely overcome on their own. So, the TARP funds are addressing the over-banked state of the financial industry and probably offsetting what would otherwise have been a drain on the Deposit Insurance Fund. I maintain that this is a good, if unintended, outcome for both the industry and the taxpayers.

I’ve heard and read comments (by people who should know better) that the hoarding of TARP funds is aiding bank earnings. Some say that those earnings are protected by TARP because it offsets credit losses. This is an accounting absurdity. The TARP will only help bank earnings if and when it is deployed successfully. This, in turn, requires two things to take place: 1) leveraging up the new capital with other sources of funds; and 2) successfully investing the proceeds in assets that provide a decent risk-adjusted return. In any event, whenever a new amount of risk-based capital comes into the equity account, the ROE will suffer for a while.

Another kind of issue with TARP, even if it isn’t needed or desired by a healthy bank, is the stigma associated with not getting it. The few banks in this category have had to go out of their way to explain why they didn’t go for it. There is a concern that, even if it really isn’t needed, a bank will be at a cash and balance sheet disadvantage in the big fish eating the little fish game.

Finally, who asked for TARP to be created? Bear and Lehman went down. Merrill was rescued. Countrywide went down early and WAMU went later. Citi is now on both a heart-lung machine and dialysis. A bunch of the big boys got killed or were in serious trouble. But not all of them. And, several of them reportedly had to be coerced into taking their share of the first $125 billion. Everyone else pretty much observed the circus on Wall Street and Capital Hill.

So, policy makers, make up your mind.  Do you want banks exercising sound credit risk management practices or not?  Do you want industry consolidation or don’t you?  Do you want sounder banks to acquire relatively weaker ones or would you rather see the FDIC pick up the pieces later?  Do you want to dictate how and when private organizations allocate risk-based capital or not?  A little clarity would be appreciated.  After all, TARP was your idea.  It wasn’t requested by the industry at large. And the flow through to businesses and consumers will take a while. Sorry. It’s in everybody’s best interest that good risk management processes prevail at this time (and always) — in granting and pricing credit, and in managing available capital. The lack of same helped get us all to this point.