The FDIC third quarter data shows bank loans down three percent nationwide. This has touched off another round of discussion about why banks aren’t lending. There are three important points to grasp.
1. Bank loans are down because they should be down.
The vast majority of our loans are to healthy well-managed businesses. With few exceptions, they have been hit hard in the last 15 months. Their volume is down on average about 25%. With lower volume, their receivables and inventory decline, cash comes in and they pay down debt. Many have been quite aggressive about cutting costs, selling excess assets and using the money to pay down debt. In short they are doing what needs to happen across the whole economy. They are deleveraging.
Distressed borrowers are having a very difficult time finding new money to borrow. It is raining and their bank wants its umbrella back. If they are wise, they are with a strong bank who will work with them. If they are with a troubled bank, it is going to be very hard to find a new bank without obtaining new equity or demonstrating an operational turn around. Even strong banks have problem borrowers. Strong banks didn’t get strong by being the easiest and cheapest lenders. Capital strength and asset quality are important to customers and they aren’t attributes achieved cheaply or by accident.
2. Bank loans are tight and expensive, because bank capital is tight and expensive.
In our state, the two largest banks are in tough shape. We take no joy from this. As I’ve said before, a real economic recovery can only happen with strong banks. One of these banks just raised $863 million of capital at about 50% of book value. The other is subject to new regulatory capital directives. This has triggered speculation that they may need to issue new equity to remain in compliance. If they had to raise capital today, it would likely also be at 50% of book value. Raising new capital at 50% of book poses a real dilemma for a responsible board and management team. If you have to raise new capital at 50% of book it means one of two things. You are either diluting your shareholders by issuing new shares at “half price” or your book value is twice the “real” value. The best way to resolve this dilemma is to shrink your assets (loans) to improve your capital ratio without selling new stock (or without selling as much new stock). A penny of capital saved is expensive dilution avoided. In other words your cheapest source of capital is to reduce your loans. A bank under pressure to shrink as a source of capital would naturally like to move its problem loans most. The reality is that the loans that can be moved are the ones that are good.
If you are forced to sell new stock at 50% of book when you believe your book value accurately states the economic value, you have a very high implied cost of capital. That new capital needs to produce a 100% return in one year to get your previous shareholders back to break even. To do that, you will only use that capital to support a new loan where you can double your money on the deal. For example, if a good clean borrower wants to borrow $1million to add a new piece of equipment, you will need $100,000 of capital to support the loan. You pay 3% on deposits and the borrower expects a 6% rate. If you make the loan, your net interest income will be about $30,000 with no provision to the loan loss reserve and no cost allocation for underwriting booking and managing the relationship. At a 3% “spread”, you really improve your earnings by maybe $15,000 in year one. If you raised that $100,000 in capital at 50% of book, your shareholders are down $85,000 in year one.
3. There is plenty of cheap cash but capital is tight.
Understanding the difference is very important. A bank charter essentially is a license to create money. Let’s say that Brokeback Bank and Trust can issue a two year CD at 2.5%. They aren’t short of cheap cash; they are short the equity that is required to keep issuing those CDs. The shortage isn’t bank deposits. The shortage is bank capital. The public would do well to understand that it is not deposit prices and availability that drive lending in times like this. It is the cost of capital that drives responsible bank behavior not the cost of depositors’ cash.
There are still banks out there with strong capital making long-term relationship decisions. This is our position as it is of all strong banks. Strong banks believe in their book value and have excess capital. It is there to provide comfort to our depositors and loans to our customers. Strong banks aren’t looking for new customers who just want a return to the low-rate, leverage orgy our country is trying to recover from. The highest deposit rates are offered by the weakest banks. Weak banks buy money because they need cash. Strong banks offer a safe refuge for their customer’s cash in stormy seas. Strong banks are safe precisely because we don’t need the cash, we want relationships. Strong banks want borrowers who understand banking enough to choose a bank that is run like a real business by real people.
TARP was intended to strengthen bank capital in order to stimulate lending. Next time, I’ll offer some thoughts on how that’s working out.