03/18/2010 05:12 am ET Updated May 25, 2011

Banks Could Heed Obama's Call To Lend More -- If They Wanted To

After his meeting with top bank executives Monday, President Obama said his main message to them "was very simple: that America's banks received extraordinary assistance from American taxpayers to rebuild their industry -- and now that they're back on their feet, we expect an extraordinary commitment from them to help rebuild our economy."

Specifically, he called on them to lend more money to small and medium-size businesses.

Could banks start doing that? Absolutely. Will they? Not if the past is any indication.

Banks certainly have money to lend. Collectively they are sitting on nearly $1.1 trillion in excess reserves, defined as cash above the level that federal regulators require them to keep. It's the highest amount ever recorded in the 50 years the government has been keeping track, even if one accounts for inflation. By comparison, in the decade before the financial crisis blew up in September 2008, the nation's banks held an average of $1.7 billion in excess reserves.

Banks' cost of funds is at record lows, thanks to the federal government. One gauge for determining banks' cost to borrow -- the Federal Reserve's interest-rate target for overnight loans between banks -- averaged 0.12 percent in November. Two years ago the rate was 4.49 percent.

Also, the spread between the interest rates at which banks borrow and the rates at which they lend to businesses is widening, according to bank loan officer survey data from the Federal Reserve.

And yet, despite all these enormous financial incentives -- and despite repeated entreaties in the past from Obama on down -- this hasn't translated into increased lending. In fact, banks' loan balances are at a two-year low. Over the past three months, loan balances at the nation's banks have averaged a bit less than $6.8 trillion, a six percent decrease from this time last year.

Loans to businesses have fared even worse. Commercial and industrial loan balances have been decreasing every month since last October, and are now down 17 percent since last year.

So what's going on?

Banks point to lower demand for loans and overleveraged consumers and businesses. Indeed, bank loan officers have been reporting lower loan demand all year, according to Fed surveys. Many businesses have cut back on investment because consumption is down, and households are saving more and spending less, cutting down their debt in the process.

But small businesses argue that demand for good-quality loans from credit-worthy borrowers is still there, and that they are hurting. "Small businesses rely on banks for 90 percent of their financing needs, compared to large businesses, which use banks for only 30 percent of their financing," said Jon D. Greenlee, associate director of bank supervision at the Federal Reserve, during a Congressional hearing last month before a House panel.

The real reason banks aren't lending? After lending too much and taking too many risks with too little capital to guard against potential losses, banks finally sustained losses last year on a scale that nearly brought down the world economy. Now they're risk averse.

Households and businesses are being asked to pony up increasing amounts of collateral before they can get a loan -- but with so much of homeowners' and small businesses' equity tied into real estate -- and with real estate values down roughly a third from their peak -- it's increasingly difficult for them to find the right level of collateral for banks to extend loans.

And besides, the country's biggest banks don't deal much in small loans -- they mostly securitize big collections of loans. With the securitization pipeline largely frozen since last fall, banks aren't finding too many willing parties eager to accept banks' risks. With no one to pass the risk off to, banks are having to stomach it themselves.

The American Bankers Association says as much. "The collapse this past year of the secondary markets for mortgages and other consumer credit products, such as credit cards and auto lending, has taken out an important pipeline of credit. Thus, many of the stories about the lack of credit are due to the weakness of non-bank lenders and the weakness of the securitization markets."