The federal government's latest effort to free up lending and tackle the financial crisis may amount to an offer bankers cannot refuse.

Despite what is certain to be tight oversight, the success of the Treasury Department's Public-Private Investment Program may hinge more on the pressure bank investors bring to bear on industry players to participate.

"Shareholders in these banks will want things to move on," said Timothy Ryan, the chief executive of the Securities Industry and Financial Markets Association, and equity investors who have watched bank stocks tumble since last year could threaten to exit the stocks unless bankers capitalize on the program.

Should they opt against selling loans into the program, observers say, bankers could face a renewed investor exodus.

Richard Bookbinder, the managing member of Bookbinder Capital Management LLC, a New York hedge fund of funds, said bankers are more likely to face pressure to participate from longer-term investors, such as large pension funds. Hedge funds and other shorter-term investors are less of a factor, he said, because they are not heavily invested in financial services companies and have bet against bank stocks lately.

Beyond the risk of alienating investors, banks have another incentive to participate in the program. Moving troubled loans and securities off their balance sheets could lure private equity into the sector — a critical step in replenishing capital after selling toxic assets at a discount.

Charles Gradante, the co-founder of Hennessee Group LLC, a New York hedge fund adviser that has about $100 million in funds targeting financial stocks, wants banks to participate. He argued that lenders can offset any resulting asset writedowns by using incoming capital to make new loans.

Shedding weak assets also would ease concerns about any "unknown" risks and could draw new investments, he said. "The lack of transparency has been one of the reasons why banks have been beaten down — because people, when in doubt, are assuming the worst."

Steven Sandler, the CEO of Crosswind Capital LLC, a New York private-equity firm that specializes in buying distressed assets, underlined the importance of transparency in patching up the banking industry.

"If you remove the uncertainty, then private equity may actually focus on the banking sector, based on the prospect for the business," he said. "That could have a major impact. Otherwise, there may not be an incentive for banks to participate."

Another factor could compel banks to participate in the government's investment program is the fact that it exists. Establishing a market for formerly illiquid residential and commercial loans would create a pricing mechanism for the assets, effectively forcing bankers to account for them.

"It turns the heat up under those bankers who claim they have recognized losses but haven't, because now there will be a marketplace," said Christopher Low, the chief economist at First Horizon National Corp.'s FTN Financial. "Once those things start to trade, those losses will have to be recognized."

Not everyone is sold on the program. Some observers said the market may price troubled assets too low.

John Kanas, a former North Fork Bancorp chairman and CEO who is now a senior adviser at W.L. Ross & Co., said the program is a good start but is unlikely to draw investment into the banking sector on its own.

"It will take more than moving toxic assets off of balance sheets," he said. "It's not very exciting if bank balance sheets simply shrink. There is still a drag on profitability if you don't have good assets lined up to replace them. For that, we need the economy to improve."

William Smith, the president, CEO and portfolio manager at Smith Asset Management Inc., counseled against moving hastily to unload troubled assets.

"What we'd like them to do is hold" the assets, said Smith, whose firm has positions in Citigroup Inc., Wells Fargo & Co., U.S. Bancorp and JPMorgan Chase & Co., among others. "It goes against everything that we're taught. You want to buy low and sell high."

A wild card is what would happen to accounting regulations. Under the mark-to-market rules currently in place, banks that shed loans at a steep discount must write down the value of those assets, taking a corresponding hit to capital. But a proposal by the Financial Accounting Standards Board to ease those rules could boost the value, if only on paper, of loans and securities formerly viewed as impaired. That, in turn, could discourage bankers from selling these assets.

Walter Todd 3rd, a portfolio manager at Greenwood Capital Associates LLC in Greenwood, S.C., said modifying accounting rules for writedowns "would create less of an incentive [for banks] to participate."

Nicholas Colas, the chief market strategist at Bank of New York Mellon Corp.'s BNY ConvergEx Group, said that not all banks would have to participate. "It could occur on a case-by-case basis."

A stock price of $10 a share would be a reasonable gauge of how investors view the strength of a given bank, he said. "Those trading above that mark may not feel an explicit need to do it. If the bank is still considered somewhat damaged goods, then anything they can do to improve transparency will be viewed favorably."

Bank analysts at Citi agreed that participating in the program would help some companies more than others and would be of particular benefit for those that have marked down significant portions of their loan portfolios. This group includes Marshall & Ilsley Corp., Fifth Third Bancorp, Regions Financial Corp., Synovus Financial Corp. and First Horizon.

In a note Tuesday, the Citi analysts also wrote that participation could help companies that bought troubled financial firms in the past year and "have already marked loans due to recent M&A."

Ultimately, the program's fate rests largely in the hands of the executives and directors running the banking companies. "At the end of the day, who drives bank policy — the shareholders or the board of directors?" Bookbinder asked.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.