Repayments will make banks weaker and could lead to more failures

Yesterday, I argued that allowing banks to repay TARP funds meant a continuation of overcapacity in financial services, which was a direct contributor to the credit crisis through its dampening impact on unlevered returns.  Some of the banks now free of the TARP restrictions are arguably still undercapitalised, but have been made to look better through various mechanisms like the relaxing of mark-to-market rules.

It stands to reason that these firms will reach for yield i.e. take on more risk in order to generate enough profits to reduce lingering capital shortages.  Remember, we still have a lot of writedowns in areas like commercial property and credit cards which have yet to be taken.  Moreover residential property prices are still falling. Just because these loans and securities are not being marked to market does not mean the losses are not there.

Below is a good video from Bloomberg News in which Boston University Professor Mark Williams argues along similar lines.  He goes as far as to say that allowing repayment now could sew the seeds of bank failures down the line.  It is very understandable that these banks want to pay back the $68 billion, but it is the job of government to regulate so as to prevent systemic risk.

Certainly, it would be a black eye for regulators if any of these banks have to come back later and ask for more money.  Irrespective, my fear is that some banks paying back or looking to pay back TARP money know they are undercapitalised and will be willing to take enough risk to ‘solve’ this problem. Think ‘savings & loan.’

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