It’s not easy being a bank these days.  Oh sure, it’s nice to still be alive.  After all, last year at this time it was uncertain exactly how many financial institutions were actually going to stay in business.  But after begging for taxpayer money to keep them alive and kicking, banks are now finding that the strings attached are more like giant anchor chains and regardless of whether an individual firm has paid back the funds or not (and really it doesn’t matter whether the institution received any funds or not), banks are now being held to a standard that requires them to focus on the public good more than the pursuit of profits.

This week, Barack Obama delivered a very pointed address to US banks, declaring that he didn’t run for office to help a bunch of “fat cats” get rich.  With many high profile banks repaying TARP liabilities and removing themselves from the compensation restrictions imposed by the government, Obama is sending the message loud and clear that banks are still required to be good stewards of their capital.  This implies that the president believes that US banks should significantly increase lending in order to supply liquidity to businesses and consumers in need of financing.

Currently, banks are enjoying one of the best rate environments possible due to the low short-term borrowing costs these institutions can take advantage of.  With the Fed Funds target rate at zero to 0.25%, banks can borrow for quite literally no interest expense (or marginal expense at worst) and invest that capital in nearly anything paying a nominal yield.  Of course Bernanke would like to see this capital lent to businesses and individuals for higher rates of return but also to prime the pump for additional economic growth.  But most recently, banks have been taking the capital they can borrow at low rates and investing in treasuries which carry a smaller profit but much more stability.

The process of borrowing cheap and investing “just a bit less cheap” does very little to stimulate our economy.  In fact, the only good it really does is to help the bank report stable profits and show a balance sheet with an improving risk picture.  (Now I’m well aware that most major banks have plenty of legacy risk associated with assets already on their books – but new lending is following the path of zero risk tolerance).  If banks continue on this path, they will likely face even more harsh criticism from an administration who believes that the financial institutions owe it to the taxpayers to be offering more liquidity.

As it turns out, the choices for banks are not pretty regardless of which angle you take.  If banks are more free with their lending, the amount of risk taken could turn out to be devastating.  This is actually a major part of the problem that got us into our difficult position in the first place.  Credit flowing freely to consumers and businesses who are not good credit risks is certainly not a good idea for the banks, or for the taxpayers.  Imagine the public backlash if these new loans turned to losses and the government had to bail out the banks again! You can bet the heads would start to roll.

But on the other hand, if the lending institutions decide not to extend credit to businesses and instead use the low borrowing rates to fortify their balance sheets, they will likely face the ire of an administration desperate to manufacture economic growth.  As it stands now, rates for borrowers are extremely low – definitely an attractive point for businesses.  But the credit standards required are extremely high.  Even showing a rock solid balance sheet, business plan, and collateral does not ensure that a business will be able to raise capital.

My personal fear is that banks are buttressing their capital base because of the off-balance sheet exposure that many still have to weak assets and structured products.  As these products are moved back on the balance sheet due to regulations imposed next year, the capital picture could turn much uglier.  With this in mind, I would recommend steering clear of major banks as an investment in the first half of 2010 while regulation continues to unfold and the picture becomes clearer.

As for the banking industry, the government should certainly continue to monitor the risk associated with these institutions, but should refrain from pushing these companies toward making loans.  Once the risk picture is cleaned up and transparency returns, competition will cause the banks to naturally lend at fair market rates.  But forcing these institutions to lend regardless of credit quality will ultimately lead to higher risk and systemic failure.

FD: Author does not have a position in stocks mentioned in this article.

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