Banking on the Government

Story Highlights:

• A second round of banks received preliminary approval to participate in the Treasury's Capital Purchase Program.
• The Treasury stated the aim of the program is to restore confidence in and between banks to increase lending. But it's not yet clear exactly how banks will deploy the extra capital.

_____________________________________________________________________________________

A second round of banks preliminary approval to participate in the Treasury's Capital Purchase Program. These 15 regional banks bring the total number of financial institutions pledging to exchange preferred non-voting shares for government funds to 24. At this point, the Treasury is not making any announcements regarding specific banks until final approval is granted—a that can take up to 30 days after preliminary approval and is subject to standard closing conditions.

The Treasury said the of the program is to restore confidence in and between banks to increase lending. But it's not yet clear exactly how banks will deploy the extra capital infusion—after all, none have received actual funds yet. The hope is banks use the extra capital to increase their lending to businesses and individuals and thereby stimulate money velocity. Still, some think banks may choose to the extra capital to strengthen balance sheets or to pay down debt in expectations of a worsening economy. Others see banks using the extra capital to consolidate with weaker banks. Several of the 15 regional banks have intentions to use the funds to expand or pursue "opportunities."

We'll likely see banks do one or a number of these moves—hopefully in the best interest of their business strategies and goals. Some the government is bolstering healthy banks with extra capital to purchase weaker banks—essentially protecting itself from further having to save weaker institutions. Treasury Secretary Paulson recently banks will not qualify for the program on a "first-come-first-serve basis"—and rather the program is designed to "attract broad participation by healthy institutions."

In some sense, it's difficult to fathom why the government feels the need to mandate capital infusions rather than simply offer help to those who need it. Stranger still, the government will impose capital upon banks but not decree its deployment (the only contractual obligation limits banks' executive compensation)—but the deployment of capital is the point of the exercise to begin with.

Banks are free to use their extra capital as they see fit. Holding onto capital could mean continued distrust in the strength of other banks or the economy. Or, using the funds to increase lending or expand business (like several intend to do) means they believe the economic outlook is positive and worth investing in. A number of factors are at play. Bank executives are undoubtedly in hunker-down mode as the prospect of profit growth relative to the risks of being subsumed by the government might appear to present an asymmetric risk to the downside. Whether that effect is real or not, it's likely to be a short-lived phenomenon. Looking ahead, the banking system is recapitalizing and capital is available. Eventually that capital will be put to work. Thawing is a good adjective—it never happens instantly.