U.S. banks have few incentives to make business loans, because Treasury Department policies have changed the economics of lending.

These changes have made it more desirable to buy Treasury, government agency, or similar securities than to lend.

The Treasury has killed lending incentives in part by:

* Advocating dramatic reductions in short-term rates while letting the dollar fall - a combination that creates a steep yield curve.

* Supporting the Basel accords on risk-adjusted capital.

* Supporting the creation of a reserving system that in effect allocates credit.

* Breaking down the trust between banks and the U.S. government.

* Discouraging actions the attractiveness of Treasury securities.

* Advocating a system of raising funds for expansion in the private market instead of tapping government-guaranteed deposits.

Dramatic Effect

These policies effectively stifle bank lending to the private sector, instead favoring the provision of monies to the federal government.

The result has been that U.S. banks have reduced their overall loans by $10 billion in the past 12 months while increasing their holdings of Treasury securities by more than 20%, or $101 billion.

A high-level Treasury official told me that my reasoning is flawed. The Treasury's most vital interests are entwined with a healthy and growing domestic economy, he said, and the propositions above fail to reflect this.

The Treasury's view is that banks are not lending because the economy is at the end of a credit cycle and demand for funds is abnormally low. Further, this view holds, bankers have changed their underwriting standards to reflect the experience of recent years, becoming more demanding in loan evaluations.

Boosting Long Rates

I would argue, however, that because the Treasury has endorsed letting the dollar slide, as is generally agreed, long-term U.S. rates must go higher to keep foreign investors interested.

It seems logical, then, to assume that long-term rates in the United States are likely to remain high until the dollar strengthens or interest rates drop in strong-currency countries.

Further, if long-term rates stay high as the dollar falls, then policies that create low short-term rates - such as those strongly advocated by the Treasury - will produce a very steep yield curve.

Consider the impact of this yield curve on bankers' use of funds.

It is not difficult to obtain a spread of 250 to 300 basis points by buying federal funds - in effect relending the money to the Treasury.

Such a "loan" has many more favorable characteristics than a conventional private-sector credit.

For example, it takes about 30 seconds to lend $100 million in the Treasury market. The administrative costs are negligible. Treasury securities have no credit risk (or market risk, unless a bank decides to mark the security to market). The security has an almost perfect liquidity and can be quickly and easily pledged as collateral. And the interest is not taxed by local jurisdictions.

No Contest

By comparison, to make $100 million in automobile loans, a banker would have to make 10,000 loans for $10,000. In the credit card sector, it would be 50,000 credit balances of $2,000. The administrative costs would be high, the credit risk higher, the liquidity and usefulness as collateral constricted.

If history is any guide, the spread on such consumer loans would be low relative to the allin spread on the "loan" to the Treasury.

Moreover, if interest rates continued to decline, the ability to turn a quick capital gain would be much easier on the Treasury security than on the private loan package, despite the prevalence of securitization.

Basel Disincentives

Under international risk-adjusted capital rules, which the Treasury Department endorses, the $100 million purchase of Treasury securities would require little or no capital backing. The same amount of private-sector loans would require $4 million in equity or $8 million in total capital.

Thus, in terms of return on equity, the private-sector loan provides a much more modest relative payoff.

The Basel rules do more than simply create disincentives to lend in the private sector. They require banks to increase capital ratios to certain predetermined levels over time. To accomplish these goals, banks have had to slow asset growth or shrink their balance sheets.

This latter goal is easily achieved by not renewing private-sector loans. In the past 12 months, banks have reduced commercial and industrial loans by $24 billion.

The Basel rules also give banks substantial incentive to convert existing loans into securities that are explicitly or implicitly backed by the U.S. government. As guaranteed securities, the converted loans no longer require sizable equity backing.

The ultimate impact is to allocate funds away from commercial and industrial lending and toward lending that can be securitized and government guaranteed.

Reserving Policies

The capital penalty placed on private-sector loans has been matched in recent years by the reserving penalty. If the regulators decide that a given industry has undesirable characteristics, they can and do require high reserves against loans to that sector.

This is a credit-allocation function with undesirable side effects. For example, an industry in effect redlined by the Office of the Comptroller of the Currency loses access to bank funds. Its outlook can become terminal as a result.

Since the Comptroller's office, a Treasury Department agency, has little interest in telling banks where they can reduce their reserves, the audits of recent years have created major disincentives to lend. In lieu of lending to the private sector, purchases of Treasury securities became quite appealing.

(Note that the Treasury has advocated higher levels of capital and reserves, in line with the Basel agreements, without knowing what levels are appropriate. No one at the Treasury or any other regulatory agency has ever looked for or developed a historical series of such information. The standards have been all art, no science.)

Deposits Discouraged

Federal Reserve flow-of-funds statistics show $604 billion in net funds were raised in the domestic debt markets last year. The Treasury, other government agencies, guaranteed mortgage pools, and state and local governments received 98% of those billions.

In fact, the Treasury had to raise $26 a second in 1991 to cover the federal deficit ($322 billion on-budget) and rollover bills coming due ($500 billion).

Thus, additional liability for FDIC insurance, which would come with bank asset growth, would create a most unwelcome problem for the Treasury: a potentially uncontrollable expense, which it does not want to have to pay.

In 1991, the Treasury tried to reduce this potential problem by restricting the universal coverage of deposit insurance. When this failed, the administration tried to pass legislation that would give unsubsidized lenders primacy in the debt markets.

It is clearly a Treasury policy to see that money the FDIC does not insure, whether debt or equity, funds the economy's growth. This means bank lending should not be stimulated. Bank lending creates the undesirable deposits that the FDIC must insure and the Treasury must guarantee.

Social Policies

Two other Treasury policies that restrain private-sector lending are social in nature, and not quantifiable, but they may be more important than the economic disincentives.

One of the first initiatives taken by Treasury Secretary Nicholas Brady in the late 1980s was to address the debts of lesser-developed counties. Rather than trying to help commercial banks get their money back, he used the power of his office to get the banks to forgive a good portion of LDC debts.

If the secretary of the Treasury is supposed to represent the interests of the U.S. banking industry, he clearly did not do so here.

More upsetting, once the debts of the Latin Americans were forgiven, funds to repay the loans began miraculously to reappear. Monies repatriated to these countries stimulated their growth - and the fortunes of numerous well-funded individuals and companies.

In the United States, meanwhile, some banks were crippled by the failure to get Third World loans repaid, and tens of thousands of bank employees lost their jobs. Presidents and chairmen of the largest U.S. banks were publicly humbled; some suffered worse fates.

The audits of smaller banks also began to have an unfavorable personal tone.

Men with 30 or 40 years' experience managing banking institutions were excoriated by examiners and media people half their age, with less than half their knowledge and experience.

Bankers, generally considered to be men of stature and substance in their communities, were widely ridiculed as stupid, corrupt, and inept.

The message got across to bank executives and directors: If you make loans, this could happen to you.

But buying Treasury securities would never lead to such gross humiliation.

The trust among banking regulators, Treasury policymakers, and bankers who make loans has been damaged, perhaps irreparably. It is as if the Treasury had said, "Only a sucker looking for trouble would make a loan."

Marking to Market

To ensure that no upset occurs in Treasury markets, the Treasury Department has decided that forcing banks to mark the value of Treasury securities to market value would be bad policy. The agency argues no evidence exists that money freed up from Treasury-security holdings would go into lending.

But marking to market would clearly introduce a major risk into the holding of Treasury securities by banks. This could push them back to private-sector lending.

If one wanted to stimulate bank lending in this country, the clear prescription would be to reverse Treasury policy. Specifically:

* Prop up the dollar and reduce long-term interest rates.

* Raise the discount rate, and cut the spread between short-and long-term rates.

* Abrogate the Basel capital rules in favor of standards based upon a scholarly study of what the ratios should be.

* Rein in the regulators and reverse the practices that result in capital allocation.

* Accept the risk implicit in FDIC insurance if banks make loans.

* Bring in regulators sensitive to the needs and interests of the American banking industry to replace the Wall Street types who now oversee it.

* Mark to market all securities on banks' books.

* Adjust tax policies to maximize the subsidies on short-term lending, not long-term lending as is presently the case.

If those who clamor for more bank loans really want what they call for, they would move in these directions to insure that banks play their traditional role in boosting the economy.

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