Should Healthy Banks Give Back Their TARP Funds?

By Reuters Staff
March 25, 2009

There’s a big gap between the amount of money that the government needs to bail out the banking system, on the one hand, and the rapidly-dwindling amount of TARP funds that it has available for that purpose, on the other. Hence all the leverage in the bank-bailout scheme. But doesn’t it then make perfect sense for all the banks which got unleveraged TARP money back in October to give it back as soon as possible, so that it can then get levered up by the PPIPs and reinjected in beefed-up form back into the financial sector?

Rick Newman, for one, thinks so. But even he is alive to the downside, as explained by Andrew Ross Sorkin:

If Goldman succeeds in returning our money, it could put pressure on other banks to give their money back, too, lest they appear weak…
The problem now is that many of them may still need the money. And yet they may try to follow Goldman’s lead.

Newman reckons that if a bunch of insolvent banks will fail upon trying to give back their TARP money, so much the better:

It’s time to identify the weakest banks and let them fail if they can’t make it on their own. Capitalism isn’t like an elementary-school soccer game, where nobody keeps score and everybody wins just by participating. It’s a Darwinian ecosystem where the threat of extinction forces organizations to adapt and make smart decisions in order to survive.

The problem is that bank failures have systemic consequences. Newman is alive to the problems associated with another Lehman, but he seems to be oblivious to the problems associated with another WaMu: the US banking system can’t easily afford the cut-off in wholesale funding that would be associated with another large group of senior unsecured bondholders losing substantially all their money.

The prize, here, is to keep the financial system alive. And right now it’s simply too interlinked to be able to cope with a substantial number of bank failures. I think that handing back TARP funds is a good idea — but only insofar as it can be done without endangering the system. Otherwise, it’s a step in entirely the wrong direction.

Reprinted from Portfolio.com

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