Why Second Stimulus Must Be Directed At Regional Banks

(MoneyWatch) 
Another round of bank deleveraging is looking more likely by the day. But this time, it will be harder to convince U.S. taxpayers of the merits of a second fiscal stimulus to bail out the big banks.

The beginning of the July 4 Holiday weekend marked an ominous note for the beginning of the third quarter in 2009, with the shuttering of six Illinois banks and one in Texas. Those bankruptcies marked a record pace in bank closures this year, bringing the grand total to 52, which is more than double the same number from the whole of last year.

According to financial experts attending the WSJ Future of Finance Initiative conference in March, another 1,500 financial institutions face closure in the next 18 months, too. The gloomy outlook became more pronounced Tuesday, when President Obama's economic advisor Laura D'Andrea Tyson said the current $787 billion stimulus package will quite possibly need a follow-up injection of capital.

But this time round, it's going to be hard to persuade the U.S. taxpayer that they should trump up more of their hard-earned dollars to save beleaguered institutions such as Citigroup and Bank of America. Even in the case of a more stable firm such as Goldman Sachs, sympathy for the bank is not running high.

There is still private capital floating around, but fiscal policymakers are making it increasingly tough for small and medium-sized banks to get any of that. In the private equity landscape, for example, there remains around $400 billion in liquid funds for investment. Amazingly however, just $1 billion of that has so far been put to use in acquiring financial firms on the cheap.

Mostly, that's because of stringent requirements by the Federal Deposit Insurance Corporation when it comes to making acquisitions. For example, according to proposed rules, in order to affect a bank takeover, a firm must maintain a Tier 1 capital ratio of at least 15 percent and own the bank for 3 years minimum. New FDIC rules would also ban "silo structures," where a controlling investment stake is kept separate from the toxic assets on the target's balance sheet.

This Time Round, Smallest First
The central problem with the previous stimulus package seems to have been that while the largest banks were super-capitalized, smaller financial firms were pretty much left to fend for themselves.

That policy agenda was a double-edged sword for most regional banks, which not only got left out of the government's Troubled Asset Relief Program funding scheme, but as a result, appeared less stable to investors and speculators, whom refused to invest when the banks tried to raise the necessary capital on the public market.

Second, the government then allowed some banks, such as Morgan Stanley, Goldman Sachs, and JP Morgan to pay back their TARP proceeds early, creating a two-tiered banking structure of clearly defined winners and losers in the credit meltdown. That only made the problem worse for smaller banks that desperately needed capital to survive -- after all, why buy Dallas-based Millennium State Bank when you could still get Morgan Stanley at a bargain price?

The "trickle-down" of confidence that the government expected to happen by over-capitalizing the largest banks and under-capitalizing the smallest ones needed to resemble a waterfall more than a dripping tap, and that didn't happen.

In the event of another fiscal stimulus, the government should take a leaf out of the homebuilding market for guidance on how to effect change in the financial services sector, and start building this time from the bottom up.

Related Reading at BNET Finance:

• Further Deleveraging Threatens Health of Banking System
• The First Signs of A Two-Tiered Banking Structure Emerge