So how did we get here?
When banks take losses on a lot of loans, it cuts into their capital—the accumulated earnings that forms their surplus of loans minus deposits. If it loses enough capital, the bank may be considered undercapitalized.
If this happens, the quickest way out is for it to shrink its asset size. That’s the easiest way for the percentage of the bank’s capital to grow. This is why a lot of banks aren’t anxious to make new loans, or even to renew existing ones. Their capital has fallen so they have to shrink. Multiply this by a couple thousand banks and you have a national credit crunch.
If we don’t want the banks to shrink, we have to help them raise more capital. But if this comes with excessive penalties, I think the banks will say no thanks, we can just shrink. Our duty is to our shareholders. And you can’t fault them, even if the result is negative for the economy.
That’s why any federal capital assistance can’t afford to be vindictive. As I’ve said before, payback is not a policy.
Douglas R. Tengdin, CFA
Chief Investment Officer
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