The “FDIC lotto” reason banks aren’t lending

By Felix Salmon
January 27, 2010
Mish, giving yet another reason why banks aren't lending:

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“A California Banker” writes to Mish, giving yet another reason why banks aren’t lending:

If you’re a bank with a relatively healthy balance sheet with adequate capital, (like us)you want to maintain surplus capital in order to stay on the FDIC’s list of banks they can transfer the loans and deposits from a failed institution into.

This is a home run for the acquiring bank and far more of an instant benefit than any new lending.

The problem here is that healthy banks end up competing with each other to have the largest capital surplus and therefore the greatest chance of being anointed in this manner by the FDIC. If everybody was lending, the FDIC would still have to place failed banks’ assets and deposits with someone. But instead we get the opposite corner solution, where nobody is lending — except, presumably, for banks which are close to failure and need all the interest income they can get. I wonder whether the FDIC has anybody thinking about how to counteract this syndrome.

9 comments

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This sounds a lot like the prisoners’ dilemma, with a Nash equilibrium at the lowest social outcome and the lowest individual outcome. All else being equal, banks should make more money lending than not lending, but this scenario induces them to behave sub-optimally.

One way to fix this is for the FDIC to simply choose a small pool of winners now. If all the banks knew in advance who would be awarded a takeover, then those not in the pool could go back to business as usual. Those in the pool should then be awarded takeovers for reasons not related to reserves like geography or management capacity. (Being in the pool means that your capital reserves are adequate.) Banks in the pool would then also want to go back to normal levels of lending.

Posted by thefinite | Report as abusive

Thefinite, that’s an incredibly smart idea! Maybe the FDIC could say, “These are the lotto winners, provided they continue to follow sound principles, maintain X numbers, and start lending.”

Posted by JonHocut | Report as abusive

I’m not convinced that the weakness in lending is largely from the supply side. (Did Mish confirm that the “CA Banker” really was?) The picture is murky, but it’s clear that small business is still not in much of a borrowing mood.

Posted by Mega | Report as abusive

Thefinite — That is brilliant and straightforward. Felix, it would be helpful if you could use your soapbox to make some noise re the above comments and solution by thefinite.

All evidence is that small businesses really are having a very hard time borrowing. Obama’s State of the Union just now pointed specifically to the problem of small business lending.

Posted by DanHess | Report as abusive

When a bank makes a new loan, no matter how profitable, the bank’s capital ratio immediately goes down. The capital ratio only recovers later (and exceeds starting level) when (and if) the loan principal is repaid and profit through the loan margin is realized. If banks are concerned about capital ratios in the near term then we have a broken market where higher price offered by customers(i.e. higher interest margins and more future profit to the banks) cannot induce lending now.

Short analysis and example of this fact(including chart) can be found at http://williamwild.blogspot.com/2009/09/ raroc-v-capital-ratio.html
Only solution is to find a way for banks to raise new, tied capital simultaneously with making new loans. http://williamwild.blogspot.com/2009/09/ evolution-of-idea-part-2.html

Posted by will1 | Report as abusive

I’m with Mega, the bigger constraint is on the demand side, but I suspect it’s primarily an issue of borrower quality. Those businesses needing to borrow now, in this environment, are probably in a bit of trouble and don’t represent the best credit risk anyway. I think you can see this at places like Lending Club as well. Discretionary borrowing from solid businesses looking to grow or expand is just not happening, not on any meaningful scale. Any business with decent cash flow is looking to de-lever, consolidate and survive. On the supply side, I think any constraint on lending has a lot to do with the bank’s uncertainty about appropriately pricing risk in this new environment.

Posted by Sensei | Report as abusive

Im with sensei. Washington is admonishing banks on one hand to “mind the bank” and make good loans, then they point the finger and say, “bad bank” when they don’t let the capital flow.

Damned if you do, damned if you don’t.

BK’s are still reeling, collateral has shrunk from the asset implosion, cash flows have consolidated to certain limited sectors, and credit scores have dropped. Even factorers and asset based collateral lenders are being defensive. So its the nature of the cycle, I think. Even if banks didn’t have risk to contend with, throwing out credit to every biz that needs capital would be creating an unstable economy and a ‘business bubble’. Maybe Peter Schiff has a valid point…systemic failure is really the only way to clean house to business valuations and asset prices down to their true values.

Posted by Dr.Savage | Report as abusive

Demand for loans is down
That’s a key reason it LOOKS like banks are not lending.

Lending standards are also rising so there are few credit worthy borrowers. Banks are lending responsibly for the first time in a decade.

Also banks are severely capital constrained.

CNN Money On Small Business Lending
http://globaleconomicanalysis.blogspot.c om/2010/01/cnn-money-on-small-business-l ending.html

Myth of Excess Reserves
http://globaleconomicanalysis.blogspot.c om/2009/12/fictional-reserve-lending-and -myth-of.html

Mish

Posted by MishGEA | Report as abusive

why lend ? the banks park taxpayer bailout bucks at the FED And get interest and next to zero risk, and other shenanigans that we all know about. We the people have been totally chumped. Oh, well… lotsa more Browns-types in congress soon. Times are a-changin’..come on, November !

Posted by gramps | Report as abusive