Monday, January 26, 2009

Why why shouldn't force banks to lend

A surprisingly common criticism of the TARP is that it didn't require banks receiving bailout money to lend to small businesses and consumers. Joe Nocera of the NYT penned a whole column about "the dirty little secret of the banking industry," which was that "it has no intention of using the money to make new loans."

Elizabeth Warren's TARP Oversight Panel has also criticized the Treasury for not requiring banks to lend money. For example, the Panel's second report stated:

If, as Treasury has stated, the goal of capital infusions was to increase consumer and small businesslending, why were funds not concentrated among businesses with substantial small business and consumer lending or authorized only when a financial institution presented a business plan to use the funds for small business or consumer lending?
The purpose of the equity injections was to recapitalize the banks, which were (and still are) woefully undercapitalized. Forcing them to immediately turn around and make more risky loans — and small business and consumer loans are historically risky loans — is a really stupid idea.

But don't take it from me. Take it from Richard Caballero of MIT, Anil Kashyap of Chicago, and Takeo Hoshi of UC San Diego. Their paper in the December 2008 issue of the American Economic Review, "Zombie Lending and Depressed Restructuring in Japan," examines "the role that misdirected bank lending played in prolonging the Japanese macroeconomic stagnation that began in the early 1990s." The paper is behind a firewall, but there's a draft version (which might differ slightly from the final version) available here. Since it's hard to understate the paper's relevance to the current criticisms of TARP, I quote at length:
This paper explores the role that misdirected bank lending played in prolonging the Japanese macroeconomic stagnation that began in the early 1990s. The investigation focuses on the widespread practice of Japanese banks of continuing to lend to otherwise insolvent firms. We document the prevalence of this forbearance lending and show its distorting effects on healthy firms that were competing with the impaired firms.
Aside from a couple of crisis periods when regulators were forced to recognize a few insolvencies and temporarily nationalize the offending banks, the banks were surprisingly unconstrained by the regulators.

The one exception is that banks had to comply (or appear to comply) with the international standards governing their minimum level of capital (the so-called Basle capital standards). This meant that when banks wanted to call in a nonperforming loan, they were likely to have to write off existing capital, which in turn pushed them up against the minimum capital levels. The fear of falling below the capital standards led many banks to continue to extend credit to insolvent borrowers, gambling that somehow these firms would recover or that the government would bail them out. Failing to roll over the loans also would have sparked public criticism that banks were worsening the recession by denying credit to needy corporations. Indeed, the government also encouraged the banks to increase their lending to small and medium-sized firms to ease the apparent “credit crunch,” especially after 1998. The continued financing, or “evergreening,” can therefore be seen as a rational response by the banks to these various pressures.
By keeping these unprofitable borrowers (which we call “zombies”) alive, the banks allowed them to distort competition throughout the rest of the economy. The zombies’ distortions came in many ways, including depressing market prices for their products, raising market wages by hanging on to the workers whose productivity at the current firms declined, and, more generally, congesting the markets where they participated. Effectively, the growing government liability that came from guaranteeing the deposits of banks that supported the zombies served as a very inefficient program to sustain employment. Thus, the normal competitive outcome whereby the zombies would shed workers and lose market share was thwarted. More importantly, the low prices and high wages reduce the profits and collateral that new and more productive firms could generate, thereby discouraging their entry and investment. Therefore, even solvent banks saw no particularly good lending opportunities in Japan.
We find that investment and employment growth for healthy firms falls as the percentage of zombies in their industry rises. Moreover, the gap in productivity between zombie and non-zombie firms rises as the percentage of zombies rises. These findings are consistent with the predictions that zombies crowd the market and that the congestion has real effects on the healthy firms in the economy. Simple extrapolations using our regression coefficients suggest that cumulative size of the distortions (in terms of investment, or employment) is substantial. For instance, compared with the hypothetical case where the prevalence of zombies in the 1990s remained at the historical average instead of rising, we find the investment was depressed between 4 and 36 percent per year (depending on the industry considered).


Don said...

I just read a Ricardo Caballero post in the FT where he says that we should get rid of capital standards:

"The question then is whether it is feasible to run a (nearly) capital-less financial system until panic subsides. If it is, then a solution to the financial crisis is in sight since it would free up trillions of dollars of hard to raise funds, covering more than even the most extreme estimate of losses."

I'm assuming that he means that doing so will allow banks to lend instead of hoarding cash for a call. But I'll ask the question that I posted him before I read that comments were confined to experts: How does this differ from AIG? We gave AIG money so that they could weather the storm and not sell their assets at a huge loss now, but wait and sell later. The FT had Liddy saying just this in November. But what's the difference in lending them money, which pays interest, and simply cutting their capital requirements and guaranteeing their losses, which we charge a nominal insurance fee on ?

As to your main point, I'm bothered by how TARP was sold, and then changed. If recapitalizing the banks without the money being deployed was the plan, then it should have been sold that way. As an average citizen, that's not how it was sold to me. I think that many citizens, like myself, are a little battered by the arguments used to sell us a plan being one thing, and then, once sold, the plans are changed to something else.

Don the libertarian Democrat

Anonymous said...

It seems that this problem may apply to zombie banks as well. Could it be that TARP is prolonging our recession by lending money to these otherwise-insolvent banks?

d4winds said...

Two of your more important quoted excerpts are (1) "the widespread practice of Japanese banks of continuing to lend to otherwise insolvent firms" and (2) “the government also encouraged the banks to increase their lending to small and medium-sized firms.” Nothing in your post indicates in the least that the volume of increased lending to “small and medium-sized firms” at government request was even remotely akin to or comparable in magnitude to the continued lending to “otherwise insolvent firms." Indeed, the anecdotal evidence from the period in news accounts was that the Japanese banks coziness with very big, but badly run business was the root of the banking solvency evils and that culturally this coziness was almost impossible to dislodge. The Japanese banks may have been to de-zombify precisely by easing the “apparent ‘credit crunch’” .

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