Orange-Hued Sticks?

Story Highlights:

• The government's taken the carrot and the stick approach to help ailing commercial banks lend, meting out via TARP both encouragement (capital infusions) and punishment (compensation restrictions and obtaining preferred bank shares).
• Politicians have not seen credit markets loosen as much as they like and are consequently demanding more accountability—and lending—from aid-recipient banks.
• Federal Reserve data released last week show business, real estate, and consumer lending all rose in 2008.
• We wouldn't be surprised if more political talk and increased regulation keep the Financials sector's stocks as a whole from rising. But as history shows, one sector's stagnation doesn't stop a broader market recovery.

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The government's taken the carrot and the stick approach to help ailing commercial banks lend, meting out via TARP both encouragement (capital infusions) and punishment (compensation restrictions and obtaining preferred bank shares). Lately, as political strings seem to tighten around banks receiving capital infusions, it's not unreasonable to wonder if those carrots weren't merely orange-hued sticks to begin with.

Banks accepting government aid are finding themselves progressively driven between a political rock and a hard place. On one hand, they are under pressure from bank regulators to tighten lending standards (not surprising since "lax" standards were frequently cited in the media for instigating much of last year's mortgage-backed securities mess). On the other hand, they face increasingly vocal criticism for not expanding their loan portfolios more, in spite of receiving capital infusions and other assistance.

Politicians have not seen credit markets loosen as much as they like and are consequently demanding more accountability—and lending—from aid-recipient banks. Partly, this is just political rhetoric—politicians want to appear critical of bank bailouts since they have become unpopular among many constituents. But some of this jawboning could lead to real pressure on banks. Perhaps even lead to lending mandates as some politicians are advocating, though historical precedent (e.g., subprime) shows these actions could be rife with unintended, negative consequences.

But surprisingly, the lending environment isn't as dire as politicians claim. Federal Reserve data released last week show during 2008 Q4, commercial bank lending increased 2.36%. For all of 2008, commercial bank lending rose by 5.63% (or $386 billion). Business, real estate, and consumer lending all rose in 2008—despite a recession and financial crisis.

Credit markets' activity show lending is still available to the credit-worthy. Much of today's credit tightness is due to the near-collapse of the "shadow-banking" system (i.e., asset securitization and money-market mutual funds)—which accounts for 33% of the credit supplied to the US economy, vs. 22% for commercial banks. This area will no doubt remain weak for some time since it was the hardest hit during the financial crisis. But remember that much of these lending types are to provide credit to financial intermediaries more so than end borrowers.

Government intrusions in lending can only make a debt crisis-fueled economic downturn worse. Still, it's not surprising banks are politically targeted today, especially those receiving taxpayer money. We wouldn't be surprised if more political talk and increased regulation keep Financials sector's stocks as a whole from rising. But as history shows, one sector's stagnation doesn't stop a broader market recovery.