Three Reasons Why Banks Aren't Lending

The government wants the banks to loan money to help businesses expand. But the banks aren't cooperating. Why? One reason is because there is more profit and less risk in using nearly interest free money from the Fed to invest in government notes and bonds.

According to Richard Suttmeier,

Banks are making a basic mistake of borrowing short and lending long, as this strategy seems to be the only risk of profitability they are willing to make. This House of Cards was a factor in the late 1980s/early 1990s, as the curve shifted to inversion, causing mismatched losses on top of bad loans.

The Federal Reserve has been keeping the federal funds rate near zero for an extended time.

The banks can therefore borrow from the Fed at a near zero interest rate and use that money to invest in longer term U.S. treasury obligations that pay interest. Borrowing short means borrowing money that is due to be repaid in a short time -- such as overnight or in a month. Investing long means putting money into fixed interest debt obligations that have a long-term maturity -- like three years or more. Except for the risk alluded to by Suttmeier, the banks see this as a nearly interest free and risk free way to use funds from the Fed to invest in government obligations for which the Fed is the guarantor of last resort.

But there is a second reason why the banks aren't lending.

Some people call it the bureaucracy.

Unlike entrepreneurs, employees have little to no incentive to assume any risk that might result in criticism from a supervisor, or even the remotest possibility of being fired. So when there are written rules to follow, they tend to follow the rules, regardless of whether those rules make sense or whether those rules are out-of-date or are inconsistent with some high level policy decision. And when employees are criticized or threatened with the loss of their job for some previous infraction of the rules, they are motivated to avoid a repeat of those occasions.

Employees of the banks perceive that failing to comply with the rules imposed by the regulators is a threat to their job security even when it is obvious to all that the rules are contrary to a new policy or even to a new law.

A third reason why banks aren't lending could be called the pendulum syndrome. When we do something that causes pain, we tend to over-react by shifting to an opposite extreme. Before the real estate bubble broke, many banks were lending money to nearly every every warm body that asked for a loan, Now they are over-reacting in the opposite direction. Lending standards have increased to such a degree that few borrowers can meet the requirements.

Meanwhile, there is a steady flow of news stories about high levels of bankruptcies, loan foreclosures and other indicators that the economy has a long way to go before there is a recovery to a relatively normal level of activity.

Just my two cents.

Vern Jacobs