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Small Banks And TARP: A Train Wreck

In the scheme of things it’s a bit trifling but this month’s report from the Congressional Oversight Committee charged with reviewing the execution of TARP and other facets of the financial services rescue is an object lesson in what can and may have gone wrong with the program. It deals with the plight of small banks that received TARP funds.

First, the numbers:

  • $205 billion was disbursed under the program to 707 banks.
  • Seventeen of 19 banks with assets greater than $100 billion received 81% of those funds.
  • Six hundred ninety banks with assets less than $100 billion received the rest of the money.
  • All of the 17 large banks have repaid their TARP investments while less than 10% of the smaller banks have done so.
  • One in seven small banks have missed a payment.
  • There is currently $24.9 billion outstanding to the small bank contingent.

The report goes into a lengthy discussion about the reasons for the disparate performance of the small banks relative to the large banks. Suffice it to say that the economy and the inability of the smaller banks to tap the equity markets are the principal reasons for the desultory performance. Significantly, the report notes that the situation might well worsen as more banks fail to maintain their dividend payments.

All of this is raising once again the question of why we included small banks in the program in the first place. After all, their failure or survival had little to do with the very real risks that the financial system was facing at the time the program was implemented. Here is the relevant discussion from the Commission:

It is also unclear whether the participation of small banks in the CPP has advanced Treasury’s broader aims for the program. Treasury’s main stated goal was to restore stability to the financial system, but the participation of small banks likely did not advance this cause. Even in the aggregate, by themselves the smaller CPP banks comprise too small a share of the banking sector to be systemically significant. Treasury’s other initial goal was to increase credit availability, but as the Panel explored in depth in its May 2010 report, there is very little evidence to suggest that the CPP led small banks to increase lending.

More recently, Treasury has articulated a different reason for opening the CPP to small institutions: fairness. In this view, Treasury had an obligation to provide smaller banks with the same access to capital as larger banks so as to avoid tilting the playing field in favor of larger institutions. Yet the ideal of fairness will be poorly served if the CPP has the effect of stabilizing large institutions while smaller institutions continue to struggle with growing losses and no capacity to repay their obligations to the taxpayers. Indeed, one of the most lasting and troubling effects of the CPP may be to increase concentration in the banking sector. In its earliest days the CPP provided a capital cushion that helped large banks weather the financial crisis and, in some cases, purchase smaller banks. Now small banks continue to struggle and the TARP provides little relief.

It’s usually wise to be especially alert when the government uses the fairness word. That’s often a sign that they are about to give money away. You won’t be surprised to learn that indeed forgiveness of some or all of TARP indebtedness is on the table or at least near the table. The Commission itself lets slip the concept in its report:

Treasury may remain invested in smaller banks through the CPP for years to come, which could destabilize the sector. The CPP was designed to provide Tier 1 capital to banks, so under the terms of the program, Treasury cannot call the investments; Treasury must remain invested in the CPP recipient until such time as the relevant regulator and the bank determine that the bank is able to pay off the CPP Preferred. While the dividend increase in 2013 may create an incentive for banks to repay, whether those repayments will be possible will depend on a variety of concerns particular to each individual bank, and a bank’s inability to repay after the dividend increase may signal weakness and increase stigma. Meanwhile, 9 percent may prove a costly dividend, and indeed some, or many, smaller CPP recipients may be forced to downsize or merge in order to pay off their investments. Treasury’s long time frame increases uncertainty, and subjects the investments to future financial shocks, management stresses, and other contingencies. In the face of these concerns, and in view of the relatively small sums involved, Treasury could consider writing off the investments. A write-off, however, would not only increase moral hazard, but might also contradict EESA’s mandate.

There never was a logical reason to extend TARP to the contingent of smaller banks that received funds. In reality, many were saved from extinction because of political connections, not for any rational economic reason. Having been the beneficiaries of an extended lease on life, it doesn’t seem unreasonable to ask them to pay back the money over the next three years or to suffer the consequences.

If the Treasury is going to fall back on a fairness argument for having included them in the first place, then it needs to hew to that line of reasoning. Fairness would also dictate that they suffer the consequences of a failure to live up to the terms of their contracts and that the taxpayer gets back the money that was advanced to them.

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