The Obama administration's new proposal to stimulate the economy would send money to smaller banks, with the hope that they would then lend it to small businesses. But because the program would rely on incentives rather than directives, those banks could conceivably end up using the money for other things.
President Obama on Tuesday announced that $30 billion in repaid TARP money will be funneled to small- and medium-sized banks so they can increase their lending to small businesses.
But the original TARP was supposed to increase lending, too. And it didn't.
The cost of the new capital under Obama's program would be five percent, which is what the banks will pay the government annually for its investment. If banks increase their business lending by 10 percent from 2009 levels, the cost would be reduced to one percent -- a locked-in rate they'd pay for the following three years.
"The more loans these smaller banks provide to creditworthy small businesses, the better deal we'll give them on capital from this fund that we've set up," Obama said.
But even the top rate is still cheaper than what banks typically pay to raise new capital in private markets. Banks pay an average of about 7.11 percent for equity capital, according to Aswath Damodaran, a finance professor at New York University's Stern School of Business. That's the cost of financing a business in exchange for giving investors a share of ownership.
So if banks want additional capital -- whether to guard against future losses or simply strengthen their financial position -- it would be cheaper for them to grab government money than to get it from private investors.
That's what happened frequently with banks that received money from the TARP program. The money was so cheap, and banks were on such bad financial footing, that many simply kept it, rather than increasing their loans.
"It is cheap, and it shouldn't be given to banks that just want to simply increase their capital," said Molly Brogan, vice president of public affairs for the National Small Business Association, an advocacy group. However, the potential to lower the cost of the capital to one percent "is a pretty strong incentive" to lend, she said.
The administration is hoping the money will be lent to the type of businesses that have "created roughly 65 percent of all new jobs over the past decade and a half," as Obama said Tuesday.
But getting smaller banks to take the money at all could be difficult.
"We've had a very hard time getting small banks to sign up for anything TARP related, because of the pounding it's taken in Congress and in the media. So, our view is that even a non-TARP program (but one that utilizes TARP funds) will need somewhat lower dividend rates to be utilized," said a senior administration official.
The type of banks eligible for this new program -- the roughly 8,000 banks with less than $10 billion in assets -- "devote the highest percentage of their lending to small businesses in their communities, accounting for over 50 percent of all small business loans nationwide, even though they make up only about 20 percent of all bank assets," the administration said in a statement outlining its proposal.
The Independent Community Bankers of America support the new initiative. In a statement, the group pointed out that "every dollar of capital that goes into community banks has the potential to be leveraged eight to ten times -- a substantial and positive impact for both small businesses and our communities."
There's no guarantee that money will go to making new loans.
Banks are already flush with cash -- they were hoarding nearly $1.1 trillion in excess reserves as of December, according to federal banking data. That money could be used for making new loans. Supply of money isn't the problem.
Simply put, demand -- for loans, goods and services -- is down. It happens in every recession. Thus, increasing the amount of money available for loans doesn't strike at the heart of the problem.
Also, banks are wary of making more loans during a recession. Loan delinquency rates are up. Banks don't want to suffer more loan losses, particularly after the hurting they've taken over the past two years. With cheap money coming their way, they could use it to buffer against future losses.
One idea that might work better would be to increase the initial cost of the new funds, yet still decreasing it if banks ramp up their lending.
Brogan cautions against making that capital too expensive, however, as it could deter banks from signing up at all.
Also, "offering this money at a higher rate would not have any congressional support," said the senior administration official.
Creating a new program, separate from TARP, could make it more attractive for banks looking to avoid the TARP stigma, said Tanya Wheeless, president and CEO of the Arizona Bankers Association. Gene Sperling, a counselor to Treasury Secretary Timothy Geithner, said Tuesday that around 600 banks that had applied for TARP funds in early 2009 dropped out of the application process because of that stigma.
Still, Wheeless doesn't expect too many banks to sign up for the program, particularly since it's subject to change.
"It may look slightly more attractive now, on paper, but that could change," Wheeless said, noting that the plan still has to go through Congress. "There's no confidence the terms would remain."
Some bankers say a better option would be to increase the government guarantee on loans made through a Small Business Administration program. The administration has done that too, but the $30 billion could instead be used to strengthen that initiative.
As Wheeless put it: "You've got the infrastructure already in place, so why design a whole new program?"