February 23, 2010
Jobs are the number one economic and political issue of the day. The loss of more than 8 million jobs since the recession began, and the failure of the economy to produce new jobs after more than two years appears to be a systemic issue. It is widely recognized that the majority of jobs in America are created by small business. So, it would behoove policymakers to examine how to incent small business to expand and create jobs. While economists believe this can be done with tax policy, there is a necessary condition that must also be present for small business, the availability of credit and liquidity.
By now, every reader is familiar with the term “Too Big to Fail” (TBTF). Those not in this club, and especially small community based institutions, can be considered “Too Small to Save” (TSTS). If we accept the premise that small business in America is the engine of job creation, then, we must conclude that financial institutions that support small business are also a vital part of the economy (the TSTS institutions) and their inability to properly function is a systemic issue.
Since the onset of the recession, aggregate loans outstanding at financial institutions have fallen in every single month. They have fallen at both TBTF and TSTS institutions, but for very different reasons:
- The TBTF institutions, those that were essentially saved by TARP, have been content to use arbitrage on their balance sheets rather than increase loans. In the arbitrage process, they leverage their balance sheets with very low cost funds (near zero deposit and borrowing costs engineered by the Fed) using those funds to purchase “riskless” U.S. Treasury securities which are seemingly in nearly infinite supply. Because Treasury securities have a zero risk weight in bank risk based capital computations, there is no need for additional capital. In effect, these TBTF institutions can expand their deposit and borrowing bases to buy the Treasury securities without the need for additional capital. Thus, since the onset of the financial crisis, the TBTF institutions have garnered a much larger market share of deposits in the U.S. Yet, while total assets have thus grown, we have seen a significant and rapid fall in their loan portfolio assets. Last November and December, when it appeared that TARP holders were going to have their bonus payments capped, these TBTF institutions were easily able to raise capital to pay back TARP. They were able to do this because the public knows that it is highly unlikely that the government will let them fail. Note that TBTF institutions are apparently willing to raise capital to pay their bonuses, but they won’t raise it with the purpose of expanding their loan portfolios! The more cynical among us believe that the government saved the TBTF (mainly Wall Street) institutions precisely because these institutions provide the government with two necessary items: 1) the machinery to place a seemingly infinite stream of Treasury debt, and 2) someone more reliable than the Chinese to buy it.
- Loans at the TSTS institutions have also been contracting, but for very different reasons. They have been unable to make loans to small business because their capital has been depleted by souring loans due to deteriorated economic conditions. Many of these small financial institutions held Fannie Mae and Freddie Mac preferred stock which initially depleted their capital when Fannie and Freddie were placed into conservatorship. At the time of the announcement of the Fannie and Freddie failures, then Secretary of the Treasury Paulson indicated that the regulators of small financial firms would “understand” and that “help” (i.e., TARP) was on the way. There has been neither regulator “understanding” nor “help” (few small institutions without a powerful Congressional champion received TARP). As the recession progressed and the credit markets collapsed, private capital was simply not available to TSTS institutions because, unlike the TBTF, TSTS institutions can fail. As loans and capital have deteriorated on TSTS balance sheets, the capacity to make loans (to small business) has disappeared.
So large banks, with the capacity to raise capital and make loans, don’t want to as the arbitrage game is too lucrative and looks to be “risk” free. On the other hand, small banks, which would make small business loans, simply don’t have sufficient capital to expand their balance sheets and can’t tap the credit markets for additional capital because of the public’s perception of the high risk of failure.
The inability of the economy to create jobs appears to be an ongoing systemic issue that the politicians in Washington can’t seem to figure out how to address. Reducing taxes on small business appears to be the favored solution of economists quoted in the media. But, helping small financial institutions raise capital would allow the flow of funds to small business to return and appears to be a necessary (but perhaps not a sufficient) condition for job growth. Unfortunately, the TARP and other related policy fiascos have so soured the public on any further taxpayer aid to the private sector that it is unlikely that the capital issues in the TSTS financial institutions can be addressed through the political process. Thus, the creation of jobs via small business, the main engine, will have to wait for the very long economic cycle associated with credit collapses to play out.
Robert Barone, Ph.D
February 23, 2010
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