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Dearth of Bank Lending is Problem for U.S. Economy

Aaron Task
Editor in Chief
Fin - Daily Ticker - US

Fed Chairman Ben Bernanke on Friday called for banks to lend more to people and businesses in low-income areas.

"Our economy is far from where we would like it to be, and many people and neighborhoods are in danger of being left behind," Bernanke said.

That's all well and good, but the reality is a dearth of bank lending is a problem for the American economy as a whole, not just for the poor. "Lending has remained stagnant or is still contracting at most U.S. banks," Bloomberg Businessweek reports, citing FDIC data.

Nearly four years after the beginning of the financial crisis, it's become apparent to just about everyone, including the Congressional Research Service, that banks were the primary (and in arguably only) beneficiaries of the bailouts and other extraordinary measures done in response to the crisis.

"That wasn't an accident; basically, it was a design principle," says Vincent Reinhart, a senior fellow at the American Enterprise Institute and a former director of the Federal Reserve's Division of Monetary Affairs.

When financial crises hit, "authorities get nervous things can only get worse so they want to keep the system as they know it in place," Reinhart says, suggesting a "basic feature" of crisis management is that financial regulators generally follow the same playbook:

  • Go easy on the biggest banks in order to protect the "system".
  • Don't force write-downs of bad loans, betting the economy will allow the system to "grow" its way out of the problem.
  • Provide credit to troubled institutions without expecting a whole lot in return.

Unfortunately, history also shows such a response typically leads to subpar economic growth and multiple recessions in the decade following a crisis, Reinhart notes. (See: Vincent Reinhart: Bernanke In Denial About Economy's Fate)

The Economy's Clogged Arteries

Instead of continuing to bail out the banks with its zero-rate policy and quantitative easing, Reinhart recommends policymakers deal with the core of the problem: Bad loans.

Bad assets are "clogging the arteries of the financial system," he says, citing under and non-performing mortgage loans as a prime example.

More than 20% of U.S. mortgage holders under water on their loans — meaning they owe more than the house is worth — so mortgage modifications on a mass scale are needed, Reinhart says. Banks "need to accept a good chunk of those mortgages aren't going to be repaid," he says. "Accept it now and deal with the issue."

Secondly, regulators must address the issue of banks being too complicated to fail. Because of "regulatory and tax arbitrage," bank balance sheets "have no meaning anymore" he says. As a result, "examiners don't understand [banks], markets can't discipline them and they can't even run themselves because they don't have effective risk controls."

In other words, not a whole lot has changed since the halcyon days before the crisis.