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There appears to be little anecdotal or statistical evidence that banks in the U.S. are making risky new investments. Indeed, most policymakers are concerned that the banks are now too riskaverse, contributing to a severe credit crunch. The good news about a credit crunch is that banks are able to turn down weak potential borrowers and to demand higher returns for supplying funds. Thus, unlike in the Savings & Loan crisis, there is strong reason to believe that banks will earn excellent returns on the new risks they take. Even the old investments that have been “marked to market” now have built in the expectation of unusually high returns, reflecting the rates of returns demanded by the capital markets today. Some may argue that the decline in new bank lending, which banks ascribe principally to a lower demand for loans, contradicts this assertion about the economic value of new loans. However, there is plenty of evidence that tighter credit criteria and higher credit charges are at work, in combination with a fall in natural demand as companies and individuals try to claw back spending.

Banks may fail to force restructurings of “zombie” borrowers. In Japan’s lost decade, the “zombie” banks begat “zombie” borrowers. The weak banks could not call their bad corporate loans and force restructurings, since this would force them to admit that their credit losses were so bad as to severely deplete, or even wipe out, their own capital. In many cases, they even made new loans to keep the borrowers temporarily afloat. So far, there appears to be little anecdotal evidence that U.S. banks are acting in this manner with their business loans. There are far more complaints about banks tightening their standards and invoking protective covenants that force restructurings than about the opposite. On the other hand, some of the reluctance to restructure individual mortgages may stem from unwillingness to crystallize losses out of concern over banks’ capital bases, although it appears that other factors are more important in the mortgage restructuring decision.

“Zombie” banks may pull back their lending. This is the opposite of the fear that banks will splash out and take too many chances. Weakened capital bases make it hard to extend new credit, unless a bank does decide to go the route of taking excessive risk in the hopes of restoring its fortunes. It may appear that this is in fact happening with the U.S. banks, since we are undergoing a major credit crunch. However, the problem is a bit different than it might appear. The banking system is actually holding onto nearly the same volume of loans as they were before the crisis. The bigger problem is that they are failing to step up to fill the very large hole created by the virtual disappearance of the securitization market.

Prior to the crisis, a large percentage of lending made its way to end investors who were not banks, usually via the securitization process. This market has largely vanished, although there are some signs of revival, in part due to help from the Fed and Treasury. If the banks were stronger, they would have been in a position to step up their lending to fill a large part of the void. It is not clear that nationalizing the weak banks would be a more effective way of filling the securitization void than would more direct actions, such as the existing Fed/Treasury efforts.

Banks that are in trouble tend to deteriorate internally. This point is difficult to prove, but it appears very likely to be operating. Good employees leave, as do good customers. Morale crumbles and political infighting worsens, making the remaining employees less productive. It might be better to undergo


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