Why Banks Aren't Lending

Yesterday, data was released confirming that lending at major TARP recipients is down significantly since last October, which is contrary to the stated goals of the program.

(Unofficially, TARP was designed to save a few very large banks from a panic, but lending volume remains highly politicized)

There are two main theories as to why banks aren’t lending. The banks say it’s on the demand side, that there aren’t as many quality borrowers looking for loans these days. Others say it’s due to the toxic assets on the bank balance sheets. The thinking is that bank executives know their asset base will deteriorate further, and so they’re holding cash for regulatory reasons.

Over at FT, to University of Chicago professors, Douglas W. Diamond and Raghuram G. Rajan, offer a third reason: Banks, they say, are expecting some eventual firesale of toxic assets in the near future. A large bank may be nationalized or otherwise forced to dump high-yielding mortgage-backed securities onto the market.

The winners, in that case, would be those firms with the dry powder to snap up those assets. And there’s precedent here for this kind of thinking. JPMorgan (JPM), for example, has benefited from its government-backed acquisitions of distressed companies (Bear, WaMu).

If this is constricting lending, the answer is for the government to be decisive about policy. Whether that means nationalize some firms, snap up toxic assets, or make clear that no bank will be forced into any kind of firesale, the answer is to break the holding pattern and give banks some idea of what they can expect.

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