Why Banks Should Lend Out Treasury's Funds

Paul Kedrosky has a peculiar argument today, saying that banks shouldn't lend the money they're getting from Treasury:

Banks are looking at a changed world, one with deleveraging everything, consolidation happening apace, and defaults almost certain to rise rapidly over the next 24 months. Imagine that despite all of this banks began "business as usual" lending. What would happen? Almost certainly the banks would see higher levels of non-performing loans and defaults on these new efforts, perhaps even to the point that they would require more capital to reduce solvency fears. And what would we say then? We'd say, "Idiots, why did you race out and loan the money that we gave you into this weakening economy?"

There are a couple of problems with this argument. The first is the idea that loans made now will have higher default rates than legacy loans: I can't for a minute see why that should be the case, given that everybody expects underwriting standards to have tighened up. But there's a big difference between tighter underwriting standards, on the one hand, and a credit freeze, on the other.

The bigger problem is that if the banks don't lend out this new money, the argument for bailing them out in the first place is severely weakened. The reason to bail out banks is that they're systemically important and that now more than ever they are crucial intermediaries who keep credit moving in the economy. (Now more than ever because the primary bond markets have completely seized up.)

If banks don't onlend Treasury's money into the real economy, then they should have been allowed to fail -- with FDIC protection for depositors, of course, and maybe even with the government nationalizing unwanted banks and taking on their senior liabilities. At least that way equity holders and sub debt holders would have chipped in a large part of the cost of the bailout.

As the recession bites, a lot of corporations are going to be looking to Washington for bailouts. The big car companies are there already; I'm sure that airlines and Big Agriculture and steel mills and all manner of other concerns will be making the trek as well. If Paul wants to defend a bank bailout which keeps banks solvent without boosting lending, he'll have to explain why all these other industries shouldn't qualify for the same kind of thing. And that's hard.