The Big Freeze

Every spring, the thawing of the Yellow River threatens lives and property across Inner Mongolia. Ice blocks break free and then pile up further downstream, causing floods and dam bursts. The Chinese army often has to shoot cannonballs at the ice to restore the river's normal flow.

In the United States, the federal government has taken a similar approach to freeing up the frozen banking system: blast away at blockages in liquidity so that banks can resume channeling funds to businesses. But it looks to be a long winter, as many lenders simply aren't ready — or willing — to see their capital dislodged. As much as they may profess to care about corporate customers, commercial banks have made their own survival priority number one.

"A couple of years ago, banking was all about leveraging capital and growing [earnings per share]," says Michael Reinhard, CFO of National Penn Bancshares, a community bank with $9 billion in assets. "Now it's about generating capital and preserving it."

What do banks have to do before they feel comfortable making loans again? Plenty. For one thing, raising capital is still a struggle, despite the government's bailout largesse. Also, risk management, both credit and otherwise, has to be retooled, especially with federal regulators, shareholders, and lawyers breathing down bankers' necks. Then there is the problem of disclosure: almost everyone is clamoring for banks to come clean about the quality of their balance sheets, which are still riddled with toxic mortgage-related assets.

But the first order of business for banks is shoring up capital. The federal government's Troubled Asset Relief Program (TARP), which morphed into the Capital Purchase Program (CPP) for injecting preferred capital into healthy financial institutions, was supposed to ease bankers' fears and thereby open the lending spigots. Since its inception last October the program had released $194 billion to 317 financial institutions by late January, a sum surpassing the gross domestic product of Israel.

Treasury and Federal Reserve officials, including Treasury's interim assistant secretary for financial stability and TARP overseer Neel Kashkari, contended that banks infused with government funds would have no choice but to lend those funds out or use them to absorb loan write-downs and restructurings. That's because in return for taxpayers' money the government took preferred shares that pay a 5 percent dividend, which rises to 9 percent after five years. "If a bank doesn't put the new capital to work earning a profit or reducing a loss, its returns for its shareholders will suffer," Kashkari said in January.

Has TARP freed up the flow of funds? At some banks, yes. Independent Bank of Michigan, with $3 billion in assets, wrote $72.4 million in new lending — equal to the total amount it received from TARP — during the one month it had the funds in its possession, says CFO Robert Shuster. (Media reports that the bank was planning to use the TARP money to buy mortgage-backed securities from Fannie Mae were incorrect, he says.) In less than a month, Sterling National Bank used half of the $42 million it received to originate new business loans, says CEO John Millman. National Penn Bancshares, which received $150 million from TARP, has written several loans, including two totaling $19 million — one to an outpatient medical facility whose lender wanted to exit the relationship and one to a retailer to finance holiday season inventory. "We don't usually get involved in large business loans, but TARP made it a whole lot easier," says CFO Reinhard.

Give TARP a Chance?
Overall, however, only a fraction of the money from what is now the Financial Stability Plan has made it from banks' vaults to companies' coffers. That despite some banks having had the capital since last October. Commercial and industrial loans on the books of U.S. banks dropped by $358 billion from November 2008 to mid-January, according to the Federal Reserve. Clearly, some larger banks are hoarding capital, bracing for a worsening economy. In the fourth quarter, for instance, Regions Financial increased its reserves at the Federal Reserve by $8 billion. It received $3.5 billion from TARP. While banks are required to hold a certain percentage of reserves against certain types of deposits, they generally try to minimize them. (In January, the Fed was paying 25 basis points on reserves.)

Bank holding company First Horizon National ($31 billion in assets), another TARP recipient, also increased its reserve cushion, in part to protect against future losses on bad loans. "We took appropriate steps to ensure that we had as much secure, non-credit-sensitive funding sources as needed," says First Horizon CFO William "BJ" Losch. "This was a secure way to protect liquidity sources and eliminate counterparty risk." But Losch admits it was also a lower-return way to invest those balances.

Some bank CFOs who have received TARP funds think the program has been unjustly criticized. "You can't lend out every dime on day one," says Shuster. "People have to give TARP some time." Independent Bank of Michigan could conservatively leverage its $72 million into more than $500 million in new loans, he points out.

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