Will Banks Lend, or Hoard, the Treasury's Money?

Treasury Secretary Paulson put $250 billion into banks to loosen the credit markets. Is that making loans easier to get?

By Michael Mandel

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SunTrust says it will make "prudent" use of its capital infustion Chris Rank/Bloomberg News

You can't ask for faster service than this: On Oct. 3, Congress reluctantly approved the $700 billion bailout bill. Ten days later, Treasury Secretary Henry Paulson decided to use the first $250 billion of that money to inject new capital into the banking system. By the end of October, the first slug of government money was on its way to some of the biggest banks in the country.

But despite the quick infusion of new funds, bankers are signaling that prudence may rule, so they may not be willing to lend as much as hoped. For example, James M. Wells III, chief executive of SunTrust Banks (STI), which will receive $3.5 billion from the government, said in an Oct. 27 statement that "as long as the current uncertain and challenging economic environment persists, maintenance of capital at elevated levels is desirable."

Politicians and regulators responded by warning banks that they had to step up to the plate. In an Oct. 28 speech, Anthony W. Ryan, acting Treasury Under Secretary for domestic finance, admonished financial institutions: "As these banks and institutions are reinforced and supported with taxpayer funds, they must meet their responsibility to lend."

The big issue is whether the combination of government money and heavy-duty jawboning will boost bank lending. Let's take a look at some of the key questions:

Have banks stopped lending?

Actually, no. Large commercial banks expanded their outstanding loans by almost $200 billion, or 5%, in the four weeks ended Oct. 15, a period that included the passage of the bailout bill. That's after doing little net lending in the first eight months of the year. Small banks showed a much smaller 1.5% increase in loans over the same four-week period.

True, given the extreme market and economic turmoil, these increases may be somewhat misleading. For example, some of the additional lending probably represents corporations drawing down already-existing bank credit lines, rather than banks actually extending new loans. Nevertheless, the increase in bank loan portfolios is a step in the right direction.

So why the worry?

The same data show that even while large banks were adding to their loans, they were also socking away $88 billion in cash. That leaves Washington concerned that any additional infusions of money will also be tucked away by the banks, to be used to fund acquisitions or to cushion more losses.

So far, however, the real slackers seem to be U.S. operations of foreign banks, which are not included in the capital injection program at this point. Over the past four weeks, they've added $68 billion to their cash stockpiles while barely increasing their lending at all.

Why are some bank executives expressing caution about using the federal money for more lending?

In large part, the bankers are managing expectations. Under ordinary circumstances, a $250 billion increase in equity capital might translate into an enormous, $3 trillion increase in lending, since banks typically make more than $10 in loans for every $1 in capital.

But given the slowing economy and the continued fall in home prices, they will need much of the government money simply to counteract almost-certain future losses on existing loans. "The $250 billion is probably about enough to plug the hole in the aggregate bank balance sheet from losses that have yet to be recognized," says Jan Hatzius, chief U.S. economist at Goldman Sachs (GS).