Lending to Those Who Need It Least, Part II

Earlier I argued that the Treasury's plan to recapitalize the biggest banks made a lot of sense because they're in the best position to restore a stable lending environment. I drew that conclusion from this paper by University of Chicago's Douglas W. Diamond on the best policies for equity injections.

The big value add that banks provide an economy is their expertise "in evaluating a borrower or in committing to providing a long-term financing policy," says Diamond. He argues that

the only case where a subsidized recapitalization may be justified is when the undercapitalized bank is one with lending relationships and viable borrowers. In all other cases, recapitalization is a government subsidy without social value...

If the reason to have a well-capitalized banking system is to ensure that new relationships can
be established, this can be achieved by recapitalizing a few of the best banks.

Let's say a bank is a "relationship lender" and is undercapitalized. Diamond argues that it doesn't make sense for the government to support this bank just enough for it to be able to write off loans or liquidate its borrowers' collateral. That's because the bank would still be under stress and would be more likely to foreclose on a borrower inorder to receive the immediate funds it needs to shore up its capital ratios. A better capitalized bank would have the abillity to let this borrower continue making payments -- a better outcome for the economy.

Too small a recapitalization (from severely undercapitalized to undercapitalized) may be bad because it will not prevent inefficient foreclosure. This is especially true if the borrowers are short on cash.

Beyond the issue of how much to inject, it's also important to determine what type of lender should get funds. It's now the government jobs to determine which institutions have and don't have viable lending relationships. For example, mortgage banks that originated subprime loans probably don't have it.

Taken together, the above would seem to support the notion that it's most important to stabilize banks like Wells Fargo and Bank of America, despite their protests.

Diamond also highlights some of the pitfalls in recapitalization. Most potentially worrisome is that the financial institutions may come to expect continued equity injections and will be less likely to make needed changes. The Japanese bank bailout in the late 1990's included certain measures that tried to abate this problem:

It is therefore very appropriate that Japanese recapitalization has been accompanied both by a promise of commitment to future prompt corrective action and employment reduction and by improved portfolio disclosure and valuation.