The Bank Lending Dilemma

Why some banks can't lend, and why those that do lend can't hold loans on their books.
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) -- Banks are sloshing around in liquidity, the economy is starting to pick up and the government is pushing them to lend more. So why are their balance sheets still rigid?

Two reasons: Capital requirements and interest rates.

Regulators haven't yet outlined post-crisis capital requirements, as they continue to hammer out official standards. But when inspecting the books of individual banks -- especially those with big commercial exposure -- regulators have been pushing firms to keep much higher reserves than in years past.

"The OCC, etc., are going in and enforcing much tougher requirements on capital and leveraging, even though it's not yet the law," says Dennis Nason, a former Wells Fargo banker who now runs an eponymous executive-search firm. "Almost every bank I know about is seeking capital, because the community banks have their assets frozen in existing commercial and other stuff."

Kevin Mukri, a spokesman for the Office of the Comptroller of the Currency, says banks are analyzed on a case-by-case basis, and that no official changes have been mandated across the industry.

"The bank's condition may warrant higher capital but that depends on the condition of the individual bank," says Mukri.

"We certainly want banks to lend to creditworthy customers," he added, but "we're going to look at underwriting standards. We know in the banking industry it loosened across all banks, so one thing we're going to do is to make sure the loans were underwritten correctly and future loans that go forward are underwritten correctly."

Mukri aptly described the situation as a "double-edged sword" -- an analogy that works for banks as well as regulators.

With the vague guidance from Washington, banks with questionable capital levels face a Catch-22: Lend and possibly get pushed to raise fresh funds, or don't lend, and miss out on profitable opportunities? Even banks that are certain they have ample cash are hesitant to lend because of the current interest-rate environment, vs. the outlook for months and years ahead.

Banks are able to borrow money from the

Federal Reserve

at 25 basis points or less. They can lend that money out to companies and individual borrowers at incredibly wide spreads, depending on the risk metrics.

Of course, banks have become more risk averse, as unemployment remains high. Borrowers have, too, after getting burned by toxic loans.

Banks have been reducing exposure to riskier, revolving debt -- such as credit cards --

at a much faster pace than non-revolving, collateralized debt for nearly two years. At the same time, borrowers have shied away from adjustable-rate loans that ballooned during the credit crisis.

Freddie Mac


said on Wednesday that borrowers "overwhelmingly" refinanced into fixed-rate mortgages, regardless of what type of loan they originally had.

So let's say you run a bank with enough wiggle room to make a traditional loan to a creditworthy borrower. The average rate on a 30-year fixed mortgage is 5%. But within a year or two -- much less 30 years -- that 5% won't be as profitable. Rates are widely expected to start trending higher by the first quarter of 2011, assuming the nascent economic recovery turns into a full-blown rebound.

Bank of America

(BAC) - Get Report


Wells Fargo

(WFC) - Get Report

are among the larger lenders that have adjusted their interest-rate hedging strategies to prepare for the shift.

"Say you put a $500,000 loan on your books at 6%, you're making money," says Nason. "But say a year from now rates are at 8%, you're losing money."

So there's the conundrum: It's still a risky credit environment, banks aren't quite sure of how much capital they ought to set aside, and even those willing to take the risk don't want to keep loans on their books because the spreads that look juicy today are poised to turn upside down pretty quickly. This will set up a tricky scenario for a financial-reform proposal that would require banks to keep a portion of any self-originated loans on their balance sheets.

But for the time being, banks are simply using their hoarded capital to buy up the glut of Treasury notes that the federal government is issuing to finance its raging deficit. Public debt has expanded by $3.7 trillion

over the past two years, and banks have been eager buyers. From their point of view, T-bills are nearly as liquid as cash, with a higher yield, and far less risk than even the most plain-vanilla loan.

"What it's encouraging the banks to do is take the money in at 25 basis points, and buy Treasury notes and have a positive spread," says Barry Sloane, CEO of Newtek Business Services, which issues SBA loans to businesses across the country.

Banks that have jumped into the refinancing wave or small-business lending have done so only because loans are backed by a government guarantee, via the Federal Housing Administration or the Small Business Administration. Therefore, they can be securitized and sold off to investors, or

Fannie Mae


and Freddie Mac in the secondary market.

So where does that leave the business of lending? A whole lot safer, a whole lot less available, and a whole lot more in the hands of Uncle Sam.

-- Written by Lauren Tara LaCapra in New York