Forget About Bank Recapitalization Or Nationalization

The US Treasury is worrying about the wrong problem.

The US is not any better off or richer if the government places its own stock in banks for the banks' toxic assets. It just moves the toxic asset problem from the right hand pocket of a potential FDIC liability to the left hand pocket of a potential US Treasury (or Federal Reserve) liability. In either pocket, US citizens still owned the potential liability and will have to make up any future shortfall through paying taxes. Furthermore, the capital base of the banks will be the same through a recapitalization as through a delay in writing down the toxic assets. Therefore, the total lending by these banks will be the same and the US economy will not be getting any economic benefit after the government's investment in these banks. Insolvency does not affect a bank's ability to be a lender, but does call into question its ability to survive as a corporate entity.

A recapitalization of the large banks is an optical trick that allows the US government to say it will not close these banks down. Unless the government reorganizes the bank and wipes out the private investors with the chance that the government becomes the sole investor, a recapitalization protects the banks' current shareholders and bondholders.

Insolvent banks pose a threat to debt holders and shareholders who face a complete loss of their investments. Insolvent banks, also, pose a threat to depositors only if the bank's income and positive cash flow are insufficient to continue paying deposit interest, deposit withdrawals and fund new lending. The large banks that the government is thinking about salvaging have sufficient positive cash flows to continue to operate. Many of the toxic assets continue to have a positive payment stream. These banks also have many cash equivalent assets such as US Treasuries, which can be converted to cash to fund lending without increasing the banks' leverage ratios and without increasing the banks' need for further capital to make loans.

Write downs of toxic assets decrease capital and accounting income, but do not decrease cash flow and sometimes actually increase cash flow because of the reduction in taxes. Capital amounts due to regulatory minimum capital requirements do impact the ability to lend. Simply allowing banks to delay writing down toxic assets (or allowing them to amortize the loss over a long time period such as on a asset cash flow matching basis), would obviate any need for the government to recapitalize these banks. It would allow banks with positive cash flows to remain sufficiently capitalized to continue to lend.

Banks were once, until about 40-50 years ago, the primary source of lending and deposit gathering in the US. With the advent of greater direct access by corporations to capital markets, private equity, hedge funds, insurance companies, non-financial lenders and with mortgage and loan securitization, bank lending has declined from 40 percent in 1980 to about 22 percent in 2008. The downward trend will continue, as banks no longer hold the monopoly on lending and are not the most efficient or knowledgeable source about borrowers.

Similarly, these days a much greater share of corporations and consumers place their funds in alternatives to FDIC insured bank deposit accounts, such as money market funds, muni and corporate bond funds, direct investment into US Treasuries, corporate bonds, municipal bonds and stocks. Like lending, banks have lost their monopoly as funds gatherers. In fact, without FDIC insurance, these large banks probably would not have been able to continue to gather and keep their deposits as the banks increased the riskiness of their assets. Either the deposits would have left these banks or demanded an interest rate higher than the return on the banks' assets.

Whatever the government decides to do with the large banks, it will not change the total bank lending in the US, but it can meaninglessly transfer potential liability from the FDIC to the US Treasury. The US government should just allow the importance of these banks to the US economy to continue to diminish. The government and the Federal Reserve should continue to focus on reinvigorating the non-bank lending and securitization in the US, which are now, as have been for a while, the primary sources for loans to the US economy. The government should just give the banks the OK not to write the down the toxic assets and then focus on the real economic problem in the US of the lack of non-bank lending and securitization. Over time, the large banks will continue to lose their importance to the US economy and whatever is done to them at a later date will no longer be a major concern.