Why Banks Aren't Lending

The Obama administration and the Fed have provided hundreds of billions of dollars in bailout money to troubled banks and have cut interest rates to near 0% trying to get banks to lend money. Unfortunately, it's not working. Here's why:

In 1933, Congress passed the Glass-Steagal act. The purpose of this act was to prevent banks from losing their customers money through risky investments. The act split banks into two categories, commercial or investment. Commercial banks could hold deposits and make loans to individuals and any money they made came from interest collected on the loans. Investment banks, on the other hand, could not hold deposits and made money by underwriting stocks and bonds and selling investment tools to corporations and firms.

This all changed beginning in 1970s. Banks pushed congress to begin deregulating, asking if they could act as both commercial banks and investment banks. Slowly, commercial banks were allowed engage in investment activity, starting at 5% of their balance sheet in the 70s. In 1999, the Banking Modernization Act was instituted which completely removed the Glass-Steagal act. Now, a bank could both hold deposits and use those deposits to fund investment.

The way banks fund investment is by taking the loan contract they make, bundle that contract with a bunch of other contracts of the same type (so, mortgages would be bundled with other mortgages) into securities, and then sell those securities to investors as Structured Investment Vehicles (SIVs) or Collaterolized Debt Obligations at a set fee and then earn commission. Therefore, the loans they would make would no longer be on their books, meaning any income or profit they make comes from selling these SIVs and CDOs, not from interest collected on the loans.

So what does this mean? It means that the only reason banks will lend is if they can then sell the SIVs and CDOs, as that is how they are going to make money. Unfortunately, there are no buyers for those things. Therefore, banks have no incentive to lend. So all that money that the banks got isn't really doing anything.

It is no longer enough to supply banks with funds to lend, or to cut interest rates. These tools would work if banks made money by collecting interest, but they no longer do that. Now, the only way to get banks to lend is to increase demand for these investment tools by boosting confidence (something the Fed has been doing with TAFs). However, there is one other way to increase lending. That would be by re-instituting the Glass-Steagal act, something that has been proposed by senators John McCain (R-Arizona) and Maria Cantwell (D-Washington). Re-instituting the act has been proposed over and over again by former Fed chairman Paul Volcker, and I completely agree that this is necessary. The purpose of the Glass-Steagal act was to prevent banks from gambling with their customers money. It is my belief that had this act not been abolished, the subprime crisis would never have happened. Not only will the re-institution of this act get banks to lend again, it will also prevent future collapses.

Unfortunately, this is unlikely to happen. As we all know, money = power, and right now, all the money is on Wall Street, who does NOT want any regulation (which is what the Glass-Steagal act is). But if congress is really concerned about the health of the economy and protecting the average consumer who keeps money in banks, they'll do this. Even if it means risking losing campaign funding.

In other words, it's not going to happen.


-The Economist.