January 15, 2009
Authored by: Walt Moeling
One issue that seems to be gaining traction is the need for banks to show how they are using TARP Capital, with a strong preference for the banks to be using TARP Capital to make loans. While the fungibility of bank capital makes it virtually impossible to directly tie any particular dollar of capital with any particular dollar lent, that fungibility also gives great leeway to community banks to demonstrate the lending impact of TARP Capital. Despite the political hot potato, we expect very few, if any, community banks to be criticized for their use of TARP Capital funds.
We do not believe that TARP Capital should fundamentally change the way in which bankers run their banks. Solely because they have TARP Capital, banks should not approve loans that they otherwise would turn down. However, any bank with additional capital, which TARP Capital provides, is in a better position to make or renew loans than that same bank would have been without TARP Capital.
A bank should be able to show that TARP Capital is “working” so long as its total loans are higher than they would have been without the TARP Capital infusion. In recognition of the current economic environment and capital restraints, we believe many banks would be actively attempting to shrink the size of the bank were they not to receive TARP Capital infusions. As a result, merely maintaining the current levels of loans could, in reality, be the result of TARP Capital increasing bank lending activity. Even Barney Frank’s proposed reform legislation acknowledges that TARP Capital may simply minimize the decline in lending that normally accompanies economic recessions. While this metric may be difficult for the Congressional Oversight Committee to accept, anytime the question is asked whether a new program is working, you have to make assumptions about what the situation would look like without the program.
As a result of the fungibility of capital and the need to compare against a hypothetical alternative universe without TARP Capital, demonstrating that a bank is using TARP Capital to lend is probably more about marketing than about accounting.
In many cases (e.g., when a bank holding company has one or more well-capitalized bank subsidiaries), it may make financial sense to delay infusing the TARP Capital funds into the bank as capital until loan demand requires downstreaming. By preserving flexibility, this approach also protects the safety and soundness of the overall system. Rather than classifying this approach as “retaining the funds at the holding company,” which communicates that a decision has been made not to use the funds to lend, we would recommend that the approach be discussed as “placing the funds on deposit at the bank to provide liquidity to the bank in order to fund loans.” While a deposit, unlike a capital infusion, does not allow the bank to leverage the TARP Capital, it still increases the ability for the bank to make loans.
Similarly, banks should use carefully chosen language to discuss the deployment of TARP Capital; language suggesting that “the funds will be used to increase the bank’s capital, which will increase the ability of the bank to lend” should be preferred over “the funds will be used to pay down fed funds borrowings.” The latter may very well be the initial use of the cash funds until loan demand develops as the bank manages its balance sheet, but it also likely misrepresents why the bank accepted TARP Capital in the first place, blurring the line between a source of capital and simply a source of liquidity.
To the extent that the bank already tracks its loan pipeline and maturing loans, we suggest adding an additional column to the report for management and/or the board to track which loans are being made or renewed “because of the TARP Capital.” This is obviously a judgment call but provides a basis for subsequent aggregation and reporting. Aggregated reports and details should then be reported to the board of directors (and included in the minutes) on a monthly basis, with open discussion as to whether their are other opportunities to fruitfully lend, or otherwise use, the TARP Capital.
After several months, we would expect that most, if not all, banks would be able to honestly express something like this: “In light of the $10 million TARP Capital infusion received by the bank, we have been able to make or renew over $30 million in new loans that we would not have otherwise been in a position to make.” While a three-times leverage may not even be sufficient to cover the dividend costs of the TARP Capital, it may go a long way to alleviate any political or customer pressure to demonstrate how the bank is using the TARP Capital. For banks looking at TARP Capital as a transient investment that they intend to redeem in three years, we would caution to not over-leverage the funds; anything more than five- or six-times leverage may ultimately cause the institution to be come addicted to the TARP Capital.
To supplement the language used by the bank and the tracking reports, we would recommend that banks receiving TARP Capital initiate a marketing campaign indicating that the bank has received TARP Capital and is now in position to make loans to qualified borrowers looking to turn around this economy. The marketing campaign may or may not be successful in actually identifying qualified borrowers (although it certainly is in everyone’s interest for qualified borrowers to get loans), but it does act as evidence to the regulators that if there is a nominal decrease in lending, it’s because of the economic environment, and not because the bank doesn’t want to lend.
Unfortunately, the economy remains in a recession, and the ultimate conclusion of that recession remains unclear. As a result, bank lending is likely to continue to be tight for the foreseeable future. However, if positioned correctly, we are not aware of a single banker who would plan on cutting back from lending merely because the bank had more capital as a result of the TARP Capital infusion. Bankers like to help people achieve their dreams by providing financial support in the form of loans. TARP Capital provides an additional resource for bankers to do so. It is incumbent on the industry, and each bank, to demonstrate that the bank is ready, willing, and able to lend “TARP Capital money” to qualified borrowers.